The imminent default plans over Russia: what will happen if the feared default finally arrives

The Russian economy is cracking, its currency has tanked, and its debt is junk. The next step is a possible default that could cost investors billions and leave the country without financing in the markets. The swap markets give a 70% chance that this will happen the same year and Fitch Ratings says it is “imminent”. Important maturities arrive this Wednesday and many investors are unaware of the vortex they face if there is default.

Warning lights flash as the Russian government faces this Wednesday the payment of 117 million dollars in interest on bonds in dollarsa key moment for debt holders who have already seen the value of their investments fall since Russia invaded Ukraine last month.

The government says that the entire debt will be paid, although it will be in rubles as long as the sanctions -imposed because of the war- do not allow settlement in dollars. Failure to pay, or payment in local currency instead of dollars, would start the clock on a possible wave of defaults of about 150,000 million dollars of debt in foreign currency, both from the government and from Russian companies such as Gazprom, Lukoil and Sberbank.

About $120 billion of current government and corporate debt outstanding is denominated in dollars, with most of the rest in euros, according to data compiled by Bloomberg. Roughly $25 billion was issued by Gazprom, the state-owned natural gas giant.

Other important ones are added to the expiration that the Kremlin faces this Wednesday. steel and mining company Severstal has a coupon that also expires on Wednesday, and both Evraz What Tinkoff Bank have interest payments due on Sunday. Gazprom has to pay next week, and is followed by other issuers like the oil refinery Sibur and the gold mining company Polyus.

The attempt to pay this debt in rubles will not bring anything good. Payment in Russian currency would still constitute a default in the eyes of most Western investors, and not just because of its recent drop in value. Six of Russia’s 15 dollar- or euro-denominated bonds contain a “withdraw” clause allowing redemption in rubles, but the two coupon bonds due Wednesday are not among them.

What will happen then if this Wednesday the non-payment occurs? If bondholders don’t get paid in dollars on Wednesday, it would be the start of a very long and complicated process. First of all, if Russia does not fulfill its obligations, there is technically a 30-day grace period that gives you until April 15 to comply.

Beyond this grace period, history dictates that a default is followed by a period of negotiation between a government and its holders of bonds to reach an agreement on the debt restructuring. This is usually done by exchanging old defaulted bonds for new, less expensive ones, either simply with lower value, lower interest payments, or longer repayment schedules, or a combination of all three.

The investors are usually reluctant to go to court and getting a formal default declared, as that could cause the entire bond to mature and potentially trigger the default of other bonds where payments have not been defaulted. But a “normal” restructuring seems unlikely in the case of Russia, since the sanctions are designed to exclude the country from world markets. Instead, investors will likely have to wait for their Russian bonds to be canceled and for the Ukraine conflict to calm downwhich could lead to a relaxation of sanctions.

Some may also want to vote quickly to demand immediate reimbursement and get court rulings by American and British judges that allow them to try to seize Russian assets abroad to increase pressure on Moscow, they point out from the Financial Times.

In the meantime, some investors hope that the default on interest will trigger the payment of the swaps credit default, derivatives similar to insurance that are used to protect against default. The decision will be made by a “determinations committee” of the financial sector, made up of representatives of large banks and asset managers in the CDS market. However, it is possible that swaps do not end up helping bondholders, as financial sanctions could hamper the intricate system used to settle the contracts.

In turn, the creditors of companies that do not pay their debts will probably have limited recourse in the short term, according to what he tells Bloomberg Tuck Hardie, managing director of Houlihan Lokey’s financial restructuring group. “In practice, those involved may only have to stare at each other for a while,” Hardie quips. “If the company is located in sovereign Russian territory, you can’t go after its assets. If it isn’t, companies may proactively seek court protection to avoid foreclosures, or they may go to leniency agreements with debtors“.

Lee Buchheit, one of the world’s leading debt restructuring experts, agrees that investors should prepare for a long haul. It suggests that creditors may also be particularly harsh on Russia for moral as well as financial reasons. “There is near-universal support for Ukraine, even among the normally hard-core institutional investors. Some of those investors might want to take a swing at the cause,” Buchheit explains. “One way to do this would be to vote to speed up Russian foreign bonds once the grace periods run out and pursue legal enforcement of the instruments. I wouldn’t be surprised if some bondholders decide to do this faster than we normally see.” after the default of a sovereign bond”.

History is an imperfect guidebut according to World Bank Chief Economist Carmen Reinhart, Russia already holds the record for the longest time elapsed between a default and some sort of resolution with creditors, the gap of almost seven decades until 1986. Such an event will revive memories of past crises, such as Russia’s in 1998, when it defaulted on part of its ruble-denominated debt, and Argentina’s three years later. Russia’s default in the late 1990s was on domestic debt, so a foreign currency default would be the first since the aftermath of the 1917 Revolution, when the Bolsheviks refused to acknowledge the tsar’s debts.

Signs of the financial damage to come are evident in many of the world’s largest money managers, such as BlackRock and Pacific Investment. But they are not likely to be limited to these giant funds. With much of Russian debt rated investment grade just weeks ago, securities were ubiquitous in fixed income portfolios and global benchmarks, meaning that the impact could extend to pension funds, endowments and foundations.

Although the debt is considerable, it is probably not enough to cause a systemic problem in the markets financial. That is the view of International Monetary Fund (IMF) Managing Director Kristalina Georgieva, who said last weekend that banks’ exposure is “not systemically relevant.”