There has been a lot of chatter over the past few weeks about Russian companies loading up on debt in anticipation of increased sanctions, and even the Russian government planning a bond issuance in Chinese Yuan for the first time out of concern that western investors may be shut out of the sovereign debt market as a result of sanctions.  U.S. sanctions targeting the debt of certain Russian companies are well-known and have been in place since 2014.  But what is underlying this renewed concern about Russian sovereign debt?

To put this into context, this is not the first time that sanctions concerns about Russian sovereign debt have arisen.  Last year, US and EU authorities warned banks not to participate in a Russian sovereign Eurobond offering, with the reported rationale being that the proceeds may be diverted to sanctioned state-owned enterprises.  (There were, at the time, no sanctions in place targeting Russian sovereign debt per se.)  That sovereign Eurobond offering ultimately succeeded, and was followed by additional issuances this year, after record performances by Russian bonds and a growing share of foreign participants in that market. 

While investor interest generally remains solid, in the last several weeks there has been a drumbeat of longer-term warning signals about the impact sanctions may have on the Russian sovereign debt market. Many investors are starting to ask whether they should be looking for an exit sooner rather than later.  This got to the point in mid-November that the Governor of Russia’s central bank had to issue a statement that there would only be a “short-term spike” in rates if expected U.S. sanctions were to materialize, followed by a sustained increase in rates of around 30-40 basis points.  Many investors would find that to be hardly reassuring.  Yields had already increased by 20 basis points in the preceding month, as this speculation grew.

So what is behind all of these financial market jitters? First, to be clear, U.S. law does not prohibit involvement in the issuance or trading of Russian sovereign debt.  But there are legal risks that market participants are seemingly only beginning to come to terms with.  On October 31, 2017, the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) issued a Frequently Asked Question (FAQ) explaining that “purchases of debt securities issued by the Government of Russia” would constitute an “investment” within the meaning of Section 233 of the Countering America’s Adversaries Through Sanctions Act (CAATSA), on which we previously advised.  (See also our broader discussion of the related guidance that has been issued under CAATSA.)  Exactly what that means is not clear, but this is certainly something for market participants to watch closely.

Section 233 of CAATSA requires the president to impose sanctions on any person that, on or after August 2, 2017, “knowingly . . . makes an investment of $10,000,000 or more (or any combination of investments of not less than $1,000,000 each, which in the aggregate equals or exceeds $10,000,000 in any 12-month period), or facilitates such an investment, if the investment directly and significantly contributes to the ability of the Russian Federation to privatize state-owned assets in a manner that unjustly benefits—(1) officials of the Government of the Russian Federation; or (2) close associates or family members of those officials.”  OFAC clarified in the FAQ that buying Russian sovereign debt can constitute a sanctionable investment if it otherwise falls within Section 233, i.e., if it meets the $10 million monetary threshold, involves the sale of rights from the state, and “unjustly benefits” someone linked to a Russian official.

Some observers have minimized the importance of Section 233 due to the “unjustly benefits” element. However, they may want to take a look at some of the U.S. Government’s recent statements about corruption in Russia.  For example, the U.S. State Department’s Investment Climate Statement for 2017 on Russia reports that “Russian officials often engaged in corrupt practices with impunity.” It states that even statistics taken from the Russian authorities reveal a remarkably pervasive level of corruption, including in the allocation of government funds, which presumably would implicate the sovereign debt market.  For example, the report states that there were nearly 33,000 crimes registered in 2016 by Russian law enforcement agencies involving bribery, kickbacks in government procurement, embezzlement, and incorrect obligation of federal and local budget funds.  Such reports would likely color how the U.S. Government views purchases of Russian sovereign debt and could certainly give rise to a risk that it would treat funding the Russian government by participating in this market as “unjustly” benefitting Russian officials or their associates.  As Section 233 only provides for “secondary sanctions,” no real proof is required, and the targets have limited legal recourse.

There are significant doubts about whether Section 233 really applies in this context.  The FAQ cited above is itself quite unclear.  It suggests that a purchase of Russian sovereign debt would constitute a potentially sanctionable “investment” if it constitutes “a loan or other extension of credit to an enterprise.” Of course, purchasing debt from a sovereign is not normally an extension of credit to an enterprise, so it would be useful for OFAC to clarify publicly what it means by this.  Still, this FAQ creates some real doubt about whether the Russian sovereign bond market is currently a sanctions target.

But the real game-changer for this market is expected to be Section 242 of CAATSA, which requires the Treasury Department to issue a report by February 2018 “describing in detail the potential effects” of expanding existing U.S. sanctions prohibiting transactions or dealings by U.S. persons in “new debt” of longer than 14 days maturity of sanctioned Russian financial institutions “to include sovereign debt and the full range of derivative products.”  The fear – not at all unfounded – is that this report could lead to the imposition of U.S. legal prohibitions on any and all dealings in Russian sovereign debt.  Maybe the debt-devouring we have seen by Russian corporates and government over the last several months is starting to look more understandable after all.