Investors in Russia’s sovereign bonds are looking further down the horizon as Vladimir Putin’s government navigates the fallout of international sanctions in order to stave off default.

A carve-out in U.S. measures against Russia has allowed overseas bondholders so far to receive payments on the nation’s foreign-currency debt, even as restrictions complicate the process. Yet it’s unclear how long that can last. While it’s possible the exemptions could be extended by U.S. authorities, focus is shifting to a showdown at the end of May -- especially as Moscow’s reserves shrink and the economy suffers.

Holders of the nation’s bond due on Monday are, of course, still on alert for a payment of more than half a billion dollars -- an amount that’s set to be Russia’s biggest debt-stress test since its troops invaded Ukraine last month. But some angst over the risk of imminent default has receded after the government bought back almost three-quarters of the once-US$2 billion security using local currency. 

Now, some investors are staring down the last week in May, when a key U.S. exemption to sanctions is scheduled to expire and Russia faces another round of dollar coupon payments.

“Russia has the capacity and willingness, and up until now, technical issues haven’t prevent it from making payments,” said Damian Sassower, chief emerging market credit strategist for Bloomberg Intelligence. “But at some point there’s so many hoops to pay creditors that, at some stage, you think: What do you think Russia’s willingness to pay is going to be?”

The current exemption, which allows U.S.-based entities and investors to receive Russian debt payments, is set to expire on May 25 unless extended by the Office of Foreign Assets Control, the body that oversees U.S. sanctions.

A senior Treasury official, speaking to reporters on condition of anonymity, said no decision has been made on the May 25 deadline. The official noted that the general license allowing routine debt payments was issued to mitigate the impact of the sanctions on Western institutions and individuals, adding that the U.S. has an interest in avoiding doing damage to Western banks. 

DEBT DAMAGE

Of course, damage has already been done in the price of the bonds. Russia’s sovereign dollar notes are down 72 per cent so far this year on average, according to data compiled from a Bloomberg index, with some maturities trading below 20 cents on the dollar. Risk premium has also skyrocketed to above 3,400 basis points over U.S. Treasuries, JPMorgan Chase & Co. data show, well above levels considered distressed. 

Meanwhile, the ruble has fallen short of erasing losses incurred in the weeks after Putin sent troops into Ukraine. It traded at 83.09 per U.S. dollar as of 6:39 a.m. in New York, more than 2 per cent weaker than its closing level on Feb. 23 -- the day before Russia launched its attack. 

If the U.S. rule isn’t extended and payments are unable to reach bondholder accounts, Russia would be at risk of its first foreign default since the Bolsheviks repudiated debts in 1918. That puts the spotlight on coupons owed on May 27 for bonds maturing in 2026 and 2036. 

“Post-May 25, the assumption still has to be that OFAC doesn’t allow any further payments, resulting in a default,” Morgan Stanley’s Simon Waever wrote in a note to clients on March 18, when reports of the first wartime coupon reached some bondholders’ accounts two days after it was due. The exemption “could be extended, yet for this to happen it would need a significant move toward deescalation.”
 

CRITICAL DEVELOPMENTS 

Developments on the ground in Ukraine and between Russia and the nations it’s deemed “unfriendly” will also be critical, with a reversal in sanctions appearing unlikely without large changes. Europe and Russia remain at odds over gas payments, a process made even more complicated by calls for new sanctions against Moscow after reports of atrocities near Kyiv. Meanwhile, President Joe Biden’s administration is channeling further military aid to the government in Kyiv.

Grace periods on some Russian corporate bonds have already expired without the money reaching creditors. In one case, Citigroup’s scrutiny prompted Russian steelmaker Severstal to run out of time to pay interest on a foreign-currency bond. 

The U.K., in a similar vein as the U.S., has also announced its own set of exemptions for financial institutions to facilitate bond-payment flows. These will last until June 30, unless extended. For investors, the worry is that sanctions meant to hamper Russia’s economy and access to financing could turn around to hit them. 

“I think those exemptions will be provided for as long as needed,” said Cristian Maggio, head of portfolio strategy at Toronto Dominion Bank in London. “It may even be on a case-by-case basis rather than having a blanket exemption. Every single payment will have to be examined and exempt which is going to make things more complicated, which is going to increase tensions in markets. It’s going to make people more anxious because it brings an additional dimension of risk to this story.”
 

DWINDLING RESERVES

The clock may also be running out for Russia’s ability to keep up with payments, regardless of sanction exemptions.  

Russia’s central bank said on Thursday its foreign-currency and gold reserves plunged to just US$604.4 billion as of March 25, the lowest level since last August. It marks a US$38.8 billion plunge since a February peak, underscoring the drain for Russia since it began the invasion. While it’s unclear exactly where Russia has been pulling funds to service its foreign debt payments so far, dwindling reserves may be a sign that its long-term debt sustainability is becoming more challenging.

The process of moving money out of Russia and into the accounts of foreign bondholders has also proven more cumbersome since the war began and sanctions piled up. Add to that ongoing lack of market liquidity and an economic outlook that is, at best, ambiguous -- and there’s likely still a lot for Russian bondholders to worry about.

“It’s going to take some time for this market to get back to where it was,” said Padhraic Garvey, head of global debt and rate strategy at ING Financial Markets. “It does feel like these sanctions are relatively structural and it would take a significant change in tone from the Russian side for the sanctions to be eased and we’re nowhere near that -- which would be needed for ruble assets to go back to where they were.”

Beyond Russian bonds, emerging-market investors will also be eyeing the following in the week ahead:

• In Colombia, the central bank will be releasing minutes on Monday for its Apr.1 policy meeting which surprised traders and economists with a smaller-than-expected rate increase
• As sanctions have sent prices soaring in Russia, weekly figures suggest headline inflation will approach 15 per cent year over year in March, with risks tilting toward an even higher number.
• Turkey’s inflation rate may hit a staggering 61 per cent in March, but this 20-year peak is unlikely to trigger a response from a politically-constrained central bank.
• The Reserve Bank of India will likely keep rates unchanged, judging that growth risks still outweigh the danger from inflation.
• In Brazil, monthly inflation should breach 1 per cent in March, reflecting pressure from food and fuel prices. The BCB indicated a rise in oil prices -- not current or expected inflation -- would be necessary to depart from its base-case scenario of a final 100-basis-point hike to 12.75 per cent in May.
• In Mexico, the minutes of the March monetary policy meeting should support expectations for the central bank to continue gradually raising interest rates.