Russia and EM Bond ETFs: What Comes Next?

The impact of sanctions on Russian debt was swift, and index providers have reacted accordingly. The impact on bond investors is hard to predict, but we note several observations.

The sweeping package of Russian sanctions introduced over the past several weeks—particularly those introduced by the U.S. Department of the Treasury’s Office of Foreign Assets Control on February 22 and 24—have had existential ramifications for Russian debt. The impact has been swift, and index providers have reacted accordingly. We believe actions that have been taken, and those expected over the next several weeks, are appropriate. We also note that the vast majority of the negative return impact on passive ETFs has already been realized.

From a debt perspective, sanctions primarily targeted Russian sovereign bonds issued after March 1 and restricted transactions in bonds issued by certain named entities, including VTB and Sberbank, two of Russia’s largest banks. However, the impact on other bonds not specifically targeted by the sanctions has also been significant. For example, although existing sovereign local currency debt was not covered, liquidity has been very low and many market participants have ceased trading in these securities. A similar scenario has played out in Russian U.S. dollar-denominated corporates. In addition, blocks on cross-border money flows have, at best, held up the payment of interest and principal to foreign bondholders for the foreseeable future. Valuations have been driven down significantly due to illiquidity, the possibility of technical if not actual defaults, and the potential for even more stringent and far-reaching sanctions. Within emerging markets local currency corporates, Russia has by far been the worst performer, losing almost all value.

Russian Bonds Have Lost Nearly 100% of Their Value

Source: J.P. Morgan as of 3/11/2022. Based on the J.P. Morgan GBI-EM Global Core Index.

The performance data quoted represents past performance. Past performance is not a guarantee of future results. Performance may be lower or higher than performance data quoted.

The result has been a decrease in Russia exposure in the J.P. Morgan GBI-EM Global Core Index from approximately 3.9% on 12/31/2021 to 0% on 3/1/2022, reflecting the bonds being marked at nearly zero by the index provider. Within emerging markets high yield corporates, the weight of Russian issuers declined to 1.1% on 3/11/2022 from 4.8% on 12/31/2021, based on the ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index.

After initially announcing that newly issued Russian sovereign bonds would not be eligible to enter its widely followed GBI-EM suite of local currency sovereign indices, J.P. Morgan also announced that all existing RUB denominated government bonds would be excluded on 3/31/2022. Accrued interest was also set to zero as of 3/7/2022. Similarly, J.P. Morgan removed U.S. dollar denominated Russian sovereign debt from its EMBI hard currency sovereign indices and CEMBI emerging markets corporates index suites beginning 3/31/2022. ICE Data Indices also announced that it would be removing all bonds issued by Russian entities from its indices on 3/31/22, set accrued interest to zero as of 3/9/22, and that it would not reintroduce Russian debt into its indices without future consultation with market participants.

Given the unpredictability of the situation as well as the market’s ongoing attempts to react to and interpret various regulatory requirements, it’s very difficult to make any predictions on the impact to bond investors beyond what we know will happen based on index provider announcements and announced sanctions.

A few observations, however, are worth noting. First, all U.S.-listed ETFs must abide by regulatory requirements, including sanctions, which can result in a higher risk of tracking error. Second, for better or worse, the majority of the price impact has already occurred. For example, local currency RUB government bonds are down more than 99% year to date. Third, liquidity in all Russian debt securities is currently very thin, but that could change by the day. There has been some trading in corporate names, for example. Lastly, passive fixed income ETFs generally use optimization to match the primary risk and return drivers of their indices in order to achieve their investment objective. In other words they do not fully replicate the index constituents, in order to manage the portfolio efficiently, taking into account factors such as liquidity and trading costs. 

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