The CDS market is clear: Russia is on the verge of its first default since the October Revolution

The swap market is clear: Russia will not pay foreign debt, and insurance against defaults (credit default swaps, CDS) will have to reward holders with billions. The value of Russian debt CDS, which is used to insure against potential defaults, has soared this week despite doubts over Russia’s plan to pay some foreign bondholders in rubles, which could or not be considered as a ‘default’. There is even concern that international sanctions and existing bond terms could complicate the settlement of the $39.7 billion in CDS.

This Thursday, swaps indicate a record probability of 71% default within this year, and 81% within five years, according to ICE Data Services. Insuring $10 million of Russia’s debt for a year costs $5.8 million up front, plus $100,000 a year. Just a week ago it cost 3.8 million in advance, and a month ago it was barely asking for 300,000 dollars a year, about 300 basis points, before the invasion of Ukraine. CDS move from asking for annual interest to requiring advance payments when perceptions of default are imminent.

“The market is now giving strong signals that it believes Russia’s CDS will have to pay,” said Jochen Felsenheimer, managing director of XAIA Investment in Munich, which trades swaps and credit default bonds. “We have seen large volumes of investors buying CDS this week and the rise from initial levels shows that.”

Investors and traders are now trying to understand whether the swaps could be liquidated if Russia pays off its foreign debt in rubles, after Putin signed a decree over the weekend allowing the Russian government and companies to pay dollar debts in local currency. with investors from Russia’s “enemy countries”, among which Putin has placed the entire EU, the US, Japan, South Korea and Singapore, among others. Russia has $117 million worth of coupons due March 16 that could go into default if they are ultimately paid in rubles.

If Russia defaults on its obligations to foreign creditors, it will be the first time since the Russian Revolution, when the Bolsheviks repudiated the Tsar’s bonds. In 1998 it stopped paying its internal debt, while the external debt was restructured.

Without precedents

The cost of insurance is also rising as the yield premium on Russian debt soars, another sign of high default risk, according to JPMorgan Chase and strategist Trang Nguyen. The disparity allows investors to benefit from simultaneously holding a bond and a CDS should the contracts pay.

“There have been concerns and questions about the ability to pay the bonds and potential settlement issues, but over the last week there are signs of increased clarity that the CDS process can work,” Nguyen said. “There is no comparable precedent.”

Russia’s dollar bond coupons next week have a 30-day grace period. If that term expires without Moscow having paid in an accepted currency, investors will ask the Credit Derivatives Determinations Committee to rule on whether the CDS can be activated and schedule a settlement auction.

“It will happen sooner rather than later, the question is what can be delivered,” Felsenheimer said. “We are all rereading the contracts and trying to understand the results. The confusion of the last week shows how many market participants do not read the fine print.”

The Determinations Committee will meet for the third time on Friday to discuss whether the ruble payment option on some of Russia’s sovereign bonds would breach exchange rules for CDS.

Right now, Russia is the litmus test for the credit derivatives market, which has come under scrutiny multiple times since the financial crisis for failing to compensate investors for losses on underlying debt.

Citigroup compared Russia’s potential liquidation problems to Portugal’s Novo Banco, which ran out of deliverable bonds in 2016 when the Bank of Portugal decided to transfer its funds to a bad bank. That event suggested that rules introduced two years earlier to fix flaws after Europe’s sovereign debt crisis were still not enough to ensure that bondholders have full protection when governments or regulators step in.