What are Russian bonds and why they might default for first time

Government bonds have always been considered ''safe''. But as US forces Russia to default on its bond payment, here is how politics is changing the meaning of Russian bonds, possibly forever.

 |  5-minute read |   11-04-2022
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Government bonds were said to be the safest form of investment. But Russia is about to default on its USD bonds. Russia was supposed to repay about USD 2 billion of its debt on 4th April 2022. But, since the US has blocked Russia from using its frozen forex reserves and is forcing it to pay in USD within the next 30 days or default, Russia and bondholders are under pressure. Here is how the story is unfolding over the last few days. 

WHAT ARE GOVERNMENT BONDS? 

Usually, when governments want to spend on infrastructure projects or conduct rapid development, they raise money from the public via a mechanism called 'bonds'. Using this mechanism, governments can raise funds in the moment from the public, say for a few years. After the project is done, they can repay the amount on maturity. So, if the govt issues a 3-year bond, the governemnt has to repay this in 3 years. If they issue a 5-year bond, the government repays it in 5 years. And so on.

But why will international and domestic residents give money to the government when they can safely deposit it in their bank accounts or invest in stock markets?

gettyimages-13734377_041122063642.jpgRussia has to repay in US Dollars. Photo : Getty Images

WHY DO PEOPLE PREFER THESE BONDS?

First, residents expect a certain level of inflation in the economy because of which they expect their spending to rise over time.  

To setoff this rise in expenditure, investors look for investments where the rate of return is higher than the rate of inflation. Govt bonds usually give a good yield and have historically been considered as ''safe'' to invest in. It is important for the government to not default since it depends on the people's money to create development and it is important for themt to have people's trust. That's why the investors don't expect government bonds to default on their coupon or principle payments.

Also, investors receive a fixed rate of return every year on their investment and receive their invested amounts back on the due date of the bond. This ensures that the investors' money is safe.

BONDS AND STOCK MARKET

Now, say you hold a 3-year Russian bond worth 1,000 Euros, which you bought three years back in 2019, and which was due to be repaid this year on 4th April.

If in 2020 or 2021, you see that you can receive a better return in say Gold or stocks, instead of the Russian bond, you can sell this bond to someone else.

Thus these bonds are tradeable on the stock market, just like stocks. 

If number of sellers of Russian bonds are more than buyers buying these bonds, the price of these bonds in the stock market will fall, say for eg to 900 Euros. But, since the interest rate paid by the Russian government will be stable, the yield rate will be high.

If number of buyers of Russian bonds is more than the number of sellers of the bond, the price of the bond can go very high. This happens when other investment alternatives don't pay as well as Russian bonds. Here yield rate of the bond will go down. 

Photo: Getty ImagesPhoto : Getty Images

 NOW WHAT IS HAPPENING TODAY WITH RESPECT TO RUSSIAN BONDS?

Here is what the situation with Russian bonds look like: 

Despite tight sanctions by western nations, Russia has avoided default on its foreign currency repayments as on March 31. 

In the last two weeks of March 2022, Russia was supposed to make multiple interest payments on its USD denominated bonds. In accordance to the schedule, Russia paid its interest expense in Dollars- $117 million in the 3rd of March and $66 million in the 4th week of March via JP Morgan. It also paid off $447 million in interest payments and principal repayments on March 31. 

Things took a turn when the April payments were due and Russia attempted to pay it off, but US blocked it. 

One of Russia's Dollar denominated bond matured on April 4 where Russia was supposed to repay the principal amount of $2 billion to its investors in Dollars. It was also supposed to make a coupon payment of $84 Million for a 2042 Bond denominated in $. 

The US Treasury, which was allowing American banks to process Russian payments to US bondholders till the last week of March, flipped its policy in the first week of April thus disallowing Russian payments to come through. This prevented Russia from using its frozen forex reserves to repay its debt. 

The US Treasury decided to not permit any Russian payments through the US fiancial systems to increase pressure on Russia and force them to choose one difficult option of the three difficult choices Russia had:

  • Either default the payment or
  • Force Russia to pay from their own unfrozen USD reserves (which were in Russia) or 
  • Pay for this payment from Russia's other Revenues

This drastically increased the risk of default by 80-90%. 

So what did Russia do? 

ap_russia_ukraine_wa_041122064406.jpgPhoto : Getty Images

Russia, who wants to pay the debt, came up with an alternative: It placed the same equivalent amount (that was to be paid to its western bondholders), in Roubles instead of USD, in a National Settlement Depository.  This just goes to indicate Russia's willingness and ability to honor its payments. In fact, though half of Russian forex reserves are frozen, it still has millions of dollars in its free reserves which it can use to repay. 

Now, since the payment did not go through on 4th April, Russia has a 30-day grace period to find a way to pay in USD. Also, the US Treasury has allowed correspondence banking, subject to approval, till 25th May. This means that Russia can pay from its own unfrozen foreign currency reserves to service bond holders till 25th May.

If it doesn't do so, this will count as DEFAULT. 

DEFAULT!

  • Russia does not pay in USD even after the 30-day grace period ends on May 3rd, 2022.
  • Russia pays the debt in Roubles (since the agreement calls for payment in USD).
  • Russia voluntarily stops payment either temporarily or permanently.

But, irrespective of whether the actual payment happens or not, credit rating agencies have already started assigning ratings to this situation. 

  1. S&P assigned a ''selective default'' rating because it is assumes that neither will bondholders convert their Rouble amounts to USD, nor will Russia pay in USD.
  2. Fitch said that the default was ''imminent''. 

WHAT ARE THE POSSIBILITIES IN CASE OF DEFAULT?

Vladimir Putin. Photo: Getty ImagesVladimir Putin. Photo: Getty Images

There are two problems that arise for Russia:

  1. The actual conversion of Roubles to USD is a task since Russian currency has fallen drastically over the last 40 days. 
  2. Russia will have to look for a way to actually pay the bondholders in USD since SWIFT is not working. 

Now if a Default actually happens:

  1. Russia will be forced to stay out of international market for the coming years.
  2. This will also trigger something called as 'Credit Default Swaps' which is basically as insurance policy taken by bondholders on possible default situations. If this happens, a committee will have to decide if the default happened and also find a way out.  

It seems like the way the situation is handled right now is important more than ever since Russia has about USD 40 billion of foreign-currency denominated debt to be repaid of which $4.5 billion of payments is due by end of 2022.  

What do you think will happen? 

Writer

Akshata Kamath Akshata Kamath @akshispublished

Akshata Kamath is a Digital Storyteller at DailyO. She loves to simplify Finance, Business, Healing and History.

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