Gramercy Funds CIO on emerging markets investing amid the Russia war, including Ukrainian bonds

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Delivering Alpha

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Emerging markets, specifically those in Eastern Europe, have been whipsawed amid the ongoing Russia-Ukraine conflict. With sanctions in place and Russia’s hard default deadline approaching in April, investors are particularly focused on the region’s sovereign debt — an area that Gramercy Funds has specialized in since its inception in 1998. 

Robert Koenigsberger is CIO of the $5.5 billion investment firm. He sat down with CNBC’s Delivering Alpha newsletter to discuss his investment in Ukrainian bonds and why a 2022 Russian default would be very different from the country’s financial crisis in 1998.

 (The below has been edited for length and clarity. See above for full video.)

Leslie Picker: You’ve been buying Ukrainian bonds. How much do you own at this point? And can you explain your thinking behind this investment?

Robert Koenigsberger: Fortunately, we owned no Russia or no Ukraine, coming into the invasion on the 24th, and quite frankly, the analytics were simple. We thought that unfortunately, the probability of an invasion was pretty much a coin toss. And back then, Ukrainian bonds were trading at 80 cents and Russian bonds were trading somewhere between 100 and 150. So we felt that maybe Ukraine had 10 points of upside in the fortunate occasion of no invasion or maybe 50 or 60 of downside. Post the 24th, we saw assets trade, bonds trade as low as perhaps low 20s/high teens and so that gave us the ability to establish initial position in Ukraine and quite frankly, be very dynamic with that position. Because we do expect that on the other side of this conflict, that yes, there will be a very strong and well supported Ukraine by the West but I would also hope and expect that bondholders will be sharing the burden and the recovery. And we’ve come up with this concept of a Ukrainian recovery bond that can help ease the bridge back to the financial markets for Ukraine eventually.

Picker: What do you make of the school of thought, though, which says to avoid Ukrainian bonds, because of the risk that Ukraine actually becomes part of Russia, which would render that debt essentially worthless?

Koenigsberger: There’s certainly this notion and let us hope that it doesn’t become a part of Russia, but we have a long history of countries that no longer exist, but their debt stocks remain. A couple come to mind – Yugoslavia, way back when. Yugoslavia failed to exist, but its debt stock was picked up by the subsequent republics that came from that. And as long as we’re talking about Russia, the Soviet Union failed, ceased to exist, but its debt stock was still honored in a debt restructuring back in ’99 and 2000…Our base case is that Ukraine will continue to exist. We don’t think it will be absorbed by Russia. It will continue to have a debt stock, it will continue to have a vast portion of the assets and the debt service capability that it has today. Of course, it’s going to take a lot of time for them to rebuild that, but I would not argue that the debt stock is worthless.

Picker: What about the debt stock in Russia right now? Have you been trying to trade that, whether on the long side or the short side? Do you have a position there?

Koenigsberger: We’re completely uninvolved in Russia. We have been uninvolved for months before the invasion. Once the invasion risk became something with substantial weight, just the risk-reward, the asymmetry just didn’t make sense. You know, post-invasion, Russia 2022 is very different than Russia in 1998-99. After that default, a lot of the pain that Russia suffered back then wasn’t necessarily all self-inflicted. A lot of the pain today is obviously self-inflicted. But let’s think about it, bottom’s up and top down why Russian debt doesn’t make sense here. Bottoms up, we’re still hearing from clients this notion of self-imposed boycotts or sanctions, I think it’s still really early in the game technically, in terms of the amount of supply that’s going to be sold by ETFs and mutual funds and long [unintelligible] emerging market debt investors at a time when the pipes are broken. And what I mean by that is the banks are ceasing trading, the pipes to settle it – the Euroclear, the DTC, what have you – are not settling. So even if you want to trade, it’s going to become difficult. So quite frankly, I see a bit of a bottoms up tsunami coming where there’s inelastic supply that holders are told to stop holding this in a world where it’s hard to get rid of holding it, which should mean lower prices. 

And then top down, what is Russia going to look like, “the day after?” And I think one has to go back and look at how unstable Russia was in the period from when the wall fell in the early 90s until when Vladimir Putin consolidated power later that decade. It was very nerve wracking having to understand who was going to consolidate power, what that was going to mean. And I remember, as an example, in the old days, when Yeltsin was the president, I used to get calls from our trading desk, and they would say, “Boris Yeltsin is in the hospital,” and we’d have to triage why he was in the hospital, because one hospital was for sobering up and the other one was the cardiac hospital. And if it was the cardiac hospital, we had to be really worried about what that meant for power on the other side of Yeltsin. And unfortunately, I think that’s where we are today. I mean, many just say the solution to Russia is that Putin is no longer there. But with the end of Putin would become the beginning of what? And so I think top down, there’s a lot of challenges about thinking about Russian debt as well.

Picker: What do you think is the likelihood at this point of a hard default, by April 15?

Koenigsberger: So default is usually about the ability and willingness for someone to pay. Certainly, in the case of Russia, they are indicating a willingness to pay, but a lack of capacity or capability. And that capability isn’t necessarily because they don’t have the financial resources. That ability is because technically, it’s going to be very difficult for them to pay…It’s not too dissimilar to Argentina, when way back when Cristina Kirchner put, I think, nearly a billion dollars in the Bank of New York, but since a court had said to Bank of New York, “You can’t afford that to bondholders,” it became known as a technical default. So I think it’s quite likely that you’re going to see a default in Russia, whether they try and pay or not. 

Picker: Do you think that this will be painful, it will choke the economy in Russia if it does go into a default or do you think they weren’t really planning on accessing the foreign markets for debt anyway? Their debt load relative to other countries their size is relatively small, only $20 billion in foreign currency debt at this point. So is it even that monumental for them from a sanctions standpoint?

Koenigsberger: I don’t think the debt and isolation is that monumental. Russia is going to suffer deep economic consequences. The velocity of these sanctions and the depth of these sanctions is unprecedented. And just put debt stock aside, I don’t really think whether they pay or not, it’s going to make a difference as to whether Russia isn’t an isolated economy, which is different than 1998-99. When they had the default back then the thought was, eventually Russia is going to want to re-access the capital markets, that the debt default is the problem itself and therefore they’re going to have to resolve that very quickly in order to get access to the markets. And in fact, that’s what happened. Within 12 to 13 months, they restructured the Vneshekonombank loans that then became Russian Federation bonds and they were able to access the markets. Whether they pay or not this week, whether they pay the April maturity is not going to get them access to the markets and it’s not going to solve the dire economic consequences that that economy is going to suffer.

Picker: What do you think are the broader implications for emerging markets? India, China [are] major trading partners for Russia so one would presume that if their economy is suffering as a result of this, that it could have ripple effects to other emerging markets, obviously, Europe and the U.S. as well. But I’m specifically interested in places that are in that emerging markets bucket that you’ve studied. 

Koenigsberger: In the case of the Russia-Ukraine conflict, the impact on the oil market, I mean, immediately you can start to see winners and losers within emerging markets. And EM is always considered to be a commodity asset class. Well, some places like Mexico are exporting oil. Some places like Turkey, are importing energy. So it’s hard to make a blanket statement in terms of what it’s going to mean. That being said, I believe that the events of February 24th took the world by surprise. It was nobody’s base case that there would be an invasion and also an invasion of what I would call a capital I invasion. Maybe there was going to be an incursion towards the east of Ukraine. But this caught everyone by surprise and therefore the ripple effect is probably going to catch people by surprise. And I think that part of the challenge here is the cumulative effect, right? I mean, we have just gone through a global pandemic and now we’re stapling right to that war in Ukraine, and the ripple effects of that.

Picker: Not to mention there’s already inflationary pressure, central banks hiking interest rates which historically have had an impact on the emerging markets. Given the complicated macro backdrop, where do you see that playing out? Who are the winners and who are the losers?

Koenigsberger: You start with oil, you start with commodities, you try and figure out which side a country or a corporation might be on that. One of the other things that may be less obvious is this notion that – and this is a blanket statement, which I don’t generally like to make, but – COVID and this crisis is going to be a bigger challenge for sovereigns and their balance sheets than perhaps it may be for corporates. So once they get about the investment implications, sovereigns may be more challenged, corporates may be a safer place to be, not unlike last year when we saw that high yield corporates in emerging markets outperformed the sovereigns. That was for a different reason, because of the higher interest rates bringing lower prices. But imagine a sovereign that has a decision of, “Do we pass through prices to our society that can’t afford these prices as it relates to food? Or do we subsidize that?” And I think the choice is going to be they’re going to subsidize to try and lessen the impact for their societies. Well, in doing so, not unlike we’ve seen with developed market balance sheets, that’s going to put stress on those balance sheets that wasn’t there before from a debt perspective, debt to GDP perspective, debt sustainability perspective. So that’s certainly one of the things to look out for out here.

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