Russia could default on its debt as soon as this month, and investors still own billions of dollars of the securities through emerging-market bond funds. Russian financial markets have been called “uninvestable” after the country’s invasion of Ukraine was met with sanctions from the U.S., Europe, and other Western nations. The sanctions, meant to isolate Russia from the global financial system, include cutting off many Russian banks from key financial infrastructure and freezing its central bank’s assets.
As a result, S&P Global Ratings downgraded Russia’s credit rating to CCC-minus, one step above default. That is either five or six notches below its prior rating, depending on the currency of its debt. The analysts wrote that Russia’s efforts to protect the ruble from impact of sanctions will “substantially increase the risk of default.” They estimated that Russia’s foreign-currency reserves may have been cut in half by the freeze on central-bank assets.
Russia’s next foreign-currency debt payment is due March 16, according to Bloomberg data. Pricing on that debt reflects substantial risk, as it was quoted around 30 cents on the dollar late Thursday on Bloomberg. If Russia does default on that debt, it would be unprecedented; during its late-1990s financial crisis it continued to pay most of its foreign-currency debt.
“It really just underscores how much risk is out there,” said Jack Ablin, chief investment officer at Cresset Capital. “We have an emerging-market debt allocation, and one of the things that I asked our due diligence team is, what do we really own here?”
Investors in ruble-denominated debt face an even bigger challenge: Investors aren’t permitted to trade newly issued ruble bonds, according to the Institute for International Finance. And while they can trade bonds issued before March 1, the sanctions effectively cut off investors from custodial accounts in Russia.
Yet emerging-market bond benchmark providers still include Russian ruble-denominated bonds in their indexes. That means passively managed emerging-market debt funds couldn’t sell the bonds even if there was a liquid market for them.
One key benchmark of emerging-market government bonds run by J.P. Morgan had a nearly 1% allocation to Russian bonds as of Feb. 28, according to the bank. That may sound small, but about $415 billion of global assets track that index. Another widely followed J.P. Morgan benchmark has a 2% allocation and is tracked by $245 billion of assets.
Altogether that means roughly $9 billion of Russian debt exposure from funds tracking those two benchmarks. The largest exchange-traded fund in that category is the iShares J.P. Morgan USD Emerging Bond ETF (ticker: EMB), which manages $15 billion.
And as of March 1, J.P. Morgan said it didn’t plan to remove outstanding Russian debt from its widely followed indexes. It said it wouldn’t include any newly issued debt from sanctioned entities, and may exclude debt of Russian companies and state-backed companies from the indexes. But the bank didn’t say it was considering the same fate for Russian government debt, which makes up the vast majority of the benchmark’s exposure.
“Normally, bonds are excluded [from indexes] if they default,” wrote David Furey, head of EMEA fixed-income strategists at State Street Global Advisors, in a March 2 piece. But that poses problems for ruble-denominated debt, because of “the inability to trade/sell existing positions” after Russia’s isolation from the global financial system.
In other words, passive funds own ruble-denominated Russian debt and will struggle to sell it—or even find market prices for it. Actively managed emerging-market debt funds held allocations to ruble-denominated Russian government debt at the end of February as well. One of the larger funds was the $2.6 billion Pimco Emerging Markets Local Currency & Bond Fund (PELBX), which had a 7.1% allocation to Russian debt at the end of January. The $1.5 billion American Funds Emerging Markets Bond Fund (EBNAX) had a nearly 3% allocation to Russian debt at the end of February.
The situation is changing fast, and the Pimco fund may have sold its holdings before the end of February. The American fund, for its part, had cut down its holdings from a 6.5% allocation at the end of 2021. A spokesman for Capital Group, American Funds’ parent, said the firm’s exposure to Russian securities was a fraction of assets under management and “we are closely monitoring the situation to assess potential impacts to client portfolios, and to adjust holdings as needed.” But many active investors may have sold those bonds in a fire sale. And with the war still raging in Ukraine, any Russian securities could become increasingly difficult to offload.
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