The devastating war and humanitarian crisis in Ukraine continues to remain in the forefront of news outlets and in the hearts of individuals around the world. Russia has beenthe recipient of financial sanctions from the west, including freezing over $300 billion of foreign reserves due to this unprovoked attack on Ukraine.
And while this article will focus on the potential financial fallout from a Russian default because of their attack on Ukraine, it cannot be stressed enough that this is a far second in importance to those individuals and families fighting for their lives and their country.
Before we jump into the potential ripple effects of a Russian default, let’s take a step back and better understand why there might be a default in the first place. For some investors, the memory of the 1998 Russian default immediately comes back into mind. Importantly, the 1998 default was only a domestic default, unlike the default on foreign debt we see today. Even with this difference it’s important to recognize that shockwaves were sent through the foreign debt markets and brought Long Term Capital Management, a Connecticut hedge fund to insolvency. (Side note: There is a fantastic book about Long Term Capital Management called When Genius Failed by Roger Lowenstein)
Up until their invasion of Ukraine, Russia had plenty of reserves to pay interest on their debt. Their cash reserves totaled around $630 billion. But once Russia invaded Ukraine, unilateral financial sanctions by the western nations have not only frozen more than half of those $630 billion but Russia was also locked out of the international banking market. So, even with $300 billion remaining in reserves, shouldn’t Russia still have no problem paying these interest payments? This is where the legalese comes into play. Since Russia cannot access foreign currencies, they only have access to rubles. There is a restriction on the outstanding Russian bonds (including the bonds with interest due as of March 17th) that interest will not be accepted in rubles. And there lies the problem and risk of default!
As of this writing Russia is trying to pay the interest with the frozen assets and the US Treasury may accept this transaction, but this may only prolong the inevitable default.
What happens if a Russian default occurs on their foreign debt obligations? First and foremost, the value of Russian bonds will plummet even farther than they already have. Currently most Russian bonds are priced at $0.20 to $0.40 on the dollar, down from $1.30 to $1.10 just over 2 months ago. So why are any pensions, investment managers, or other professionals holding Russian bonds? Unlike prior defaults (Russia 1995-1998, Argentina 1998-2002, Greece 2009-2015) this potential default will have occurred in in a matter of months; leaving investors little time to exit large positions prior to dramatic price changes.
If Russia defaults on its debt, there are some minor ripples that would directly occur. A number of mutual funds carry Russian debt exposure, but the absolute highest (to public knowledge) is GQG Partners Emerging Markets Equity (Ticker: GQGRX) at 16.6%. For funds like this, the default will hurt, but very likely not put them in a position to be the next Long Term Capital Management.
Additionally, another item to consider is that while Russia has about $40 billion in foreign sovereign debt outstanding, Russian corporations have $110 billion in foreign debt outstanding. These entities which have also been closed off to the foreign financial markets may not have the same capability as the sovereign to utilize frozen assets to pay bond debt and therefore also risk default on their obligations.
If that isn’t bad enough, according to This Wall Street Journal article, there are currently about $6 billion dollars linked to credit default swaps (“CDS”) on Russian debt. These are the same instruments Warren Buffet famously called “financial weapons of mass destruction” in 2002 and the same derivatives that brought the financial world to its knees in 2008 & 2009.
There’s the bad news, but let’s look for some the silver lining through this crisis. Most financial institutions and regulators have said a Russian default would create an event that is “not systemically relevant”. Additionally, there have been questions about whether a payment in rubles would even trigger the credit default swap market.
Lastly, many investors have a diversified portfolio with little/no exposure to Russian debt obligations. Those investors include Innova Wealth Partners clients. And, while shockwaves of a Russian default may create ripples across multiple markets, a portfolio of diversified assets and geographies should limit most risk associated with such an event.
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