• Moscow last week made payments to holders of two dollar-denominated Russian sovereign bonds, maturing in 2022 and 2042 and worth a collective $650 million.
• Russia has benefited from an exemption in U.S. sanctions that allows bond payments to be made on Russian sovereign debt from sources authorized by the Treasury on a case-by-case basis.
• However, this exemption expires on May 25, and MSCI suggested that unless extended, it could trigger a default event when several Russian bond payments are due on May 27.

Although Russia has so far averted a historic debt default since sanctions were imposed on its foreign currency reserves, analysts believe it is delaying the inevitable.

Moscow last week made payments to holders of two dollar-denominated Russian sovereign bonds, maturing in 2022 and 2042 and worth a collective $650 million, before the end of a 30-day grace period on May 4.

The Russian Finance Ministry initially tried to make the payments in rubles on April 4 when the U.S. Treasury Department blocked an attempt to pay from dollar reserves held at U.S. banks. A large portion of the Central Bank of Russia's vast foreign currency reserves held with overseas banks has been frozen by international sanctions imposed following its invasion of Ukraine.

Major rating agencies said this would have constituted the country's first foreign debt default since 1917, had Russia not met its foreign currency obligations by the end of the grace period. Russia found a source of funds that were not subject to sanctions, allowing payments on the two bonds.

The successful delivery of payments prompted a rally in Russian hard-currency sovereign bonds, but prices for Russian government bonds remain well below the levels seen prior to Russia's invasion of Ukraine on Feb. 24.

In a note last week, MSCI Research said that despite the rally, "probabilities of default implied by the credit-default-swap market were still exceptionally high across the one- and five-year horizons."

"Although the resulting rally in Russian sovereign bonds may have encouraged some investors that Russia will avoid default, probabilities of default implied by the credit-default-swap (CDS) market were still exceptionally high across the one- and five-year horizons," said MSCI Managing Director Andy Sparks and Vice President Gabor Almasi.

"As of May 3, the default probability was 67% over one year, down from over 95% on April 26. Over the same period, the five-year default probabilities fell from 99% to 88%."

All eyes to May 25

Russia has benefited from an exemption in U.S. sanctions that allows bond payments to be made on Russian sovereign debt from sources authorized by the Treasury on a case-by-case basis.

However, this exemption expires on May 25, and MSCI suggested that unless extended, it could trigger a default event when several Russian bond payments are due on May 27.

"Alternatively, extending the exemption could provide additional payments to bondholders as long as the Russian government signals a willingness and ability to continue making payments," MSCI added. The Treasury has not yet indicated whether it plans on extending this exemption.

In servicing the $650 million in coupon and principal payments last week, Russia's Finance Ministry showed that it does not want a default and understands that the consequences would be "extremely damaging and long felt," according to Timothy Ash, senior EM sovereign strategist at BlueBay Asset Management.

Ash agreed that the key question now is whether the U.S. Office of Foreign Assets Control will extend the general license for foreign debt service beyond May 25.

"A view has been that it is beneficial for the U.S. to allow Russia to draw down scarce FX (foreign exchange) liquidity beyond that frozen by the West. But actually, I think the benefits of seeing this liquidity drawn down very marginally with a few billion external debt service here and there pales into insignificance when thinking of the economic and PR hit to Russia of a sovereign default," Ash said in an email Friday.

"The Russians themselves revealed their own cost-benefit calculations by paying earlier this month – so the interests of OFAC surely now are the opposite."

Ash questioned why OFAC would extend the license given that it would be "to the clear benefit of Russia," and suggested that a more pertinent question would be whether Russia can still find a way to avoid default if OFAC refuses to extend.