Sanctioning Russian sovereign debt

Sanctioning Russian sovereign debt
The US Treasury Department has sanctioned some of Russia’s top companies and businessmen.
By bne IntelliNews May 3, 2018

The US Treasury Department (USTD) decision to sanction some of Russia’s top companies and businessmen has made Russian assets “nuclear toxic waste” again, but so far Congress has held back from dropping the actual nuclear bomb: banning investors from holding or investing into Russia’s sovereign bonds.

The idea of sanctioning Russia’s sovereign bonds — especially the ruble denominated Ministry of Finance treasury bills, the so-called OFZs — has been floated several times this year. At the start of April a bill was submitted to the US Congress by representative Joaquin Castro of Texas entitled "Stand with UK against Russia Violations Act", which proposes putting investment into Russia’s sovereign bonds off limits to US investors.

But US Treasury Secretary Steven Mnuchin said in February and again in April that this "nuclear option" of sanctioning Russian sovereign debt is still a “bad idea.”

“The USTD has not put sanctions on OFZ as that would be shooting themselves in the foot. A lot of US pension funds hold Russian debt and many of them have to since Russia regained investment grade status,” says Nikolai Andreev, head of CEEMA trading at Exotic.

More broadly, to suddenly make several tens of billions of widely held bonds almost worthless would cause havoc in the international financial markets. The US Treasury Department said such measures are deemed “too risky” and carry “negative spill over effects into global financial markets and businesses” in a report released on February 2.

The OFZs have become extremely popular with international investors, who own a third of all the outstanding bonds, ever since the Russian capital market was hooked into the global financial system in 2012, as part of a revolutionary reform to the capital markets.

Foreign capital has flooded into these high yielding rock-solid bonds, rising to a peak of RUB785bn ($12.6bn) in February as foreigner’s share rose to a record 34% of all the outstanding bonds. In the fixed interest rate version of the bond, foreigners own a full half of all the outstanding OFZ bonds.

Russia also has very popular sovereign Eurobonds — the share of foreign investors in the Eurobonds is currently 37% — and used to issue $7bn a year. But that was cut to $3bn after the sanctions war started following Russia’s annexation of the Crimea peninsular in 2014.

Not that the finance ministry needed the international money. The sovereign Eurobond issues have always been more of a benchmarking exercise to allow the market to price corporate Eurobond issues that can be priced as a spread against the sovereign.

The Ministry of Finance has been relying for several years on the domestic market for its funding. The budget has RUB1.1 trillion ($17.7bn) of OFZ issues pencilled into the budget every year for the next three years. And issuing OFZ has become a lot easier and cheaper since the international investors arrived.

But with relations at a two-decade low it remains possible that the US will simply lash out and ban the bonds. As Tim Ash, head of strategy at Bluebay Asset Management, said in a recent note: “The point of effective sanctions is if you a serious about them you have to bear the pain they inflict on you as well as inflicting pain on the target.”

What would happen if they were put in place?

Of course there would be an immediate sell off, which would hurt everyone, US investors included. After the initial firestorm died down the Russian government would be cut off from a major source of budget deficit funding.

However, currently that would be an inconvenience more than a problem. In 2016, the Ministry of Finance was getting desperate as it tried to fill a RUB2 trillion hole in the budget and simply didn't have the cash to cover it. But since then costs have been cut to the point where the break-even oil price for the budget is between $53 and $64, according to various estimates, and oil was over $75 per barrel as of April 25. Russia Inc is making money and the budget could end in surplus this year.

Investors would have the same problem with the OFZ as they do with the sanctioned corporate bonds: to whom can they sell them? If the Kremlin offered to buy the foreign-held OFZs ironically it would make a killing as it could retire the bonds at pennies on the dollar, reducing its already very low external debt (14% of GDP) massively at little cost and make its economy even more resilient to sanctions in the process.

The finance ministry will have to issue some bonds especially if Russia suffers another oil price shock, but economists say that there is plenty of money inside the country to cover a lot of bond issues.

The biggest pool of money is the RUB25 trillion of retail deposits with Russian banks – well over twenty times the finance ministry’s annual OFZ borrowing plans.

Since the crisis started in 2008 Russians have taken to saving heavily and deposits have also become the main source of funding for the Russian banking sector. The finance ministry started tapping this lake of liquidity by issuing “People’s Bonds” that target retail investors earlier this year. Sberbank issued the first RUB50bn tranche of these bonds in September last year and VTB issued a second tranche in November.

Even easier to tap is the banking sector which has been piling up cash as a result of the new budget rule that forces the Central Bank of Russia (CBR) to sterilise excess oil revenues and in effect floods the banking sector with money.

“Banks are awash with cash and they are looking for targets to soak up some of their excess liquidity. They are primed for bond issues,” says Alexei Tchernitsev, head of fixed income trading at BSC Global Markets.


Ruble bond issuance RUB bn






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Source: MOEX