Investors affected by Russia’s debt default may have to settle some of their positions secretly if the U.S. Treasury does not approve an auction that would allow billions of dollars of insurance to be disbursed.
Russia in June defaulted on its international bonds for the first time in decades pressured by Western sanctions. While investors have already written off a huge part of their debt holdings, an unresolved question is how they can recover some of those losses through credit default swaps (CDS) – insurance against defaults. U.S. bond giant PIMCO holds a huge chunk of those CDS.
Yerlan Syzdykov, global head of emerging markets and co-head of emerging markets fixed income at Amundi, who holds both Russia bonds and CDS, stated:
“If this is not resolved for months and months, maybe there is an opportunity to settle in a private way.”
An auction would normally be held to decide on the price of the underlying bonds, but the Treasury’s Office of Foreign Assets Control (OFAC) last month prohibited U.S. investors from purchasing any Russian securities in secondary markets. That has darkened the outlook for an auction and sent investors seeking alternatives.
“This is unprecedented” in the CDS market, said Gregory Chartier, a senior associate at law firm Clifford Chance.
Syzdykov said his firm was working with lawyers to look at other alternative plans:
“And then maybe start negotiating directly with counterparties and determine some kind of a settlement solution outside of the auction process if it were not to happen.”
A lawyer conversant with the matter said should the terms of the contracts not be applicable due to sanctions, CDS issuers and investors could attempt to settle through bilateral negotiations.
Since it would be criminal under OFAC guidance for a U.S. seller of protection to obtain Russian bonds through a so-called physical settlement, a potential solution would be a cash settlement, in which the price of the bonds is determined by asking for quotes from dealers, said Chartier.
One of the most vulnerable parties to CDS is PIMCO, which manages assets worth $2 trillion and had “sell protection” notional exposure to Russian CDS of about $1 billion by the end of March, meaning in case of a credit event it could have to pay up to that amount.
PIMCO also had more than $1.5 billion of Russian government bonds at the end of March, even though their market value by then had fallen to around $180 million.
For CDS issuers, the payout could have been an opportunity to receive delivered bonds that are currently trading at massive discounts and continue to hope they could earn value should the Ukraine crisis find a resolution, financial sources have said.
PIMCO refused to comment.
When CDS pay out, bond investors are allowed to deliver their bonds to the CDS seller and collect 100% of the bond’s par value in return, but if they don’t actually have the bonds, they need to purchase them from someone who does.
That process is made easier by what is known as the CDS bond auction, when participants study the bond markets and determine the value of the underlying bonds.
The bond market equivalent of an insurance payment arbiter is the Credit Derivative Determinations Committee (CDDC), which last month postponed the decision on holding an auction to enable investors evaluate OFAC guidance.
Investors and lawyers have said it would possibly be seeking a solution with OFAC that would approve CDS settlements. The U.S. Treasury refused to comment and the CDDC failed to respond to a request for comment.
There are $2.54 billion of net notional CDS unsettled concerning Russia, according to recent JPMorgan calculations. Russia did not pay $1.9 million of extra interest on a bond payment in May, which the CDDC determined was a “credit event,” meaning it would initiate the payment of Russian CDS.
Since then, the CDDC, which includes banks and fund managers, has given several statements deferring a decision on how to hold an auction. On Wednesday, it said it would convene again next week.
“No one really knows what will happen if the auction can’t go forward,” said the lawyer with knowledge of the matter. “I think everyone is nervous.”