Carnage in the Russian bond and equity markets has ensued, with investors not just offloading sanctioned assets, but panic selling debt and equity of companies that could be targeted next. There are fears anything Russian in the capital markets is vulnerable.
The notice last week was largely unexpected, with little indication beforehand that the US Treasury's Office of Foreign Assets Control (OFAC) was intending to impose some of its severest penalties on Russian businesses, upping the ante by proving it was willing to hurt the interests of US investors if that meant battering Russia more grievously.
It is a line that now crossed, makes it far more unpredictable what moves will next be taken, with even a sanctioning of Russian sovereign debt — a possibility that seemed to have been dismissed earlier this year — once again being discussed.
Before last Friday the only previous movement on Russia by the US this year had been the production of a list of the world’s wealthiest Russian businessmen published in January, a move widely dismissed as little more than a copy and paste job from public sources.
In 2014 when the US and EU slapped sanctions on several state-owned Russian entities, the approach was much softer. Investors were banned from buying more debt from the listed entities, but current holdings were left untouched.
This time around, the insistence that investors dump securities before May 7 of En+, GAZ group and Rusal, has been much more severe.
One fixed income investor in London described the move as “brutal”.
“I compare it to exploding a nuclear bomb on an offshore island, just to show what you can do,” he said.
For another 12 companies named on Friday, the US Treasury said any contracts and activities must be terminated in 60 days. Assets were also frozen of seven of the country's oligarchs and 17 senior government officials.
The move was a response to Russia's alleged meddling in the 2016 US presidential election as well as the involvement the country has had in Crimea, eastern Ukraine and Syria.
The document in January now looks far more ominous in light of the designations last week.
“This is meant to rattle the cage and to let Russia know that this is only going to get worse, and that in our view was the implication with that first list in January,” said a US-based emerging markets equity fund manager. “Anybody who stepped in front of that train thinking that was the last of it, and I know lots of funds who did, are now feeling the pain.
“It just points to the fact that if you invest in EM you really have to do your homework on the macro side. It isn’t enough that the stocks are cheap, otherwise you learn this lesson the hard way. This market is about liquidity and being able to buy and sell your stock. There is now a flight out of Russia, just look what’s happened to the rouble. That affects equity markets.”
The investor said that his firm had made a decision in January to have no Russian exposure, which led to his firm underperforming other EM managers who were overweight in Russia in the first quarter. That was a decision that this week paid off, though he was very much in the minority. Some research suggests that three quarters of global emerging markets managers were overweight Russian equities ahead of the imposition of this round of sanctions, with money having flowed into the country after it was upgraded to investment grade earlier this year.
Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers pointed out that investors had been long Russia on the back of strong oil prices and higher yields against a backdrop of falling inflation and the Central Bank of Russia cutting rates, which also helps explain the sharp reaction.
According to another London-based investor, Russian sovereign hard currency bond spreads this week widened from around 185 to 211, as measured by the JP Morgan EMBI index. Russian corporate spreads leapt by 18% to 395 over Treasuries, as measured by JP Morgan CEMBI Broad Diversified index.
As well as the hit to Russian bonds and equities, the rouble on Thursday was down 13% against the dollar.
Corporate casualties
The most visible casualty from last Friday’s designation is Oleg Deripaska, the charismatic oligarch behind Rusal and the holding company En+, which controls both Rusal and a number of hydroelectric assets, which floated in London and Moscow last November.
The share prices of both have suffered severely since the announcement with Rusal down 53% in Hong Kong and En+ 34% down in Moscow. Rusal’s $500m 2023 bonds, which had only been sold in January, were on Thursday marked at a cash price of 40 having been trading at 98 on Friday, but had become illiquid with banks having stopped making a market in the notes, Bloomberg also stopped quoting prices and there was uncertainty over whether clearing houses will continue to settle trades in the debt, help to pay coupons or redeem the bonds at maturity.
What is perhaps frightening many buyers is that the sanctions list seemed almost random, not going after close allies of Russian president Vladimir Putin, but prominent businessmen with less of a direct link to the Kremlin.
Anyone, anytime
In the FAQ’s section on the US Treasury website, the department makes clear that OFAC has the authority to impose sanctions on potential targets in any section of the Russian economy in the future and that the point of sectoral sanctions is to impose costs on the Russian Federation.
What makes the next stage even more difficult to predict is that usually when it comes to a sanctions programme the sanctions are targeted at particular bad actors, or close affiliates of the targeted governments. Sanctions against Iran were an example where the US went much further than that but with Russia, until now, there has been an element of predictability to the sanctions programme.
“If you were really to scrutinise the authorities which are in place, particularly executive order 13662, which allows for the imposition of sanctions on any sector of the Russian economy that the Treasury Department sees fit, that is aimed at whatever the US sees at a strategic sector of the Russian economy,” said Anthony Rapa, a lawyer in the Washington DC office of Steptoe. “It is not targeting the bad behaviour of the sanctioned person but it is intended to weaken the Russian economy.
“So at any time, if there is a deepening of this crisis, I can see the US going after other major companies or other prominent oligarchs.”
Financial terror
This potential for further sanctions is what is driving outflows from Russia. For Russian issuers hoping to finance in the international markets in the near future the news flow of the past week is likely to have been a real blow.
“This is big news I think it now casts a shadow over new equity issuance from Russia because nobody can be 100% sure of what is coming next, we saw the list of names that was released in January and that gives an idea about who could now potentially be sanctioned next,” said a London-based investment banker with a number of Russian clients. “It is not good news at all.”
The possibility of further sanctions is likely to be dependent on whether Russia’s “malign” behaviour is deemed to have improved with several investors pointing to actions in Syria being now the most closely watched.
“I think the January list was a shot across the bow and a guide post,” said Rapa. “I think what tends to happen with these types of sanctions is that now the US has made a very bold move, arguably a destabilising move, now there could be a period of weeks or months to see if the designations have had the intended affect and whether Russia is going to change its behaviour.”
Investors will now be waiting to see what happens next and whether the sanctions are the first of many, or simply a warning.
“It will be interesting to see what happens with Russia’s place in the capital markets going forward,” a London-based investor said. “It is putting them in a very difficult position.”
“There will be technical default situations as a result of an inability to access markets, if a company is unable to pay a coupon because of the sanctions, even if they actually have the money,” the investor added.
For many bond and equity investors who have pulled out of Russia, or those who were thinking about adding Russia to their portfolios, the risk of further sanctions might simply be too great.
“There is a lot of risk there still and we really don’t know how this is going to play out,” said the US investor. “We’re a global fund and can buy any company out there and don’t have to buy Russian oil or Russian banks for example, there are hundreds of banks and oil companies we can buy.
“Why take that risk right now and if I’m thinking that I’m sure a lot of other funds are thinking that as well.”
Additional reporting by Aidan Gregory and Virginia Furness.
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