Gramercy Funds Emerging Markets CIO Investing Amid Russian War, Including Ukrainian Bonds

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Emerging markets, particularly those in Eastern Europe, have been taken aback by the ongoing conflict between Russia and Ukraine. With sanctions in place and Russia’s default deadline approaching in April, investors are particularly focused on the region’s sovereign debt – an area in which Gramercy Funds has specialized since its inception in 1998.

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

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

Leslie Picker: You bought Ukrainian bonds. How much do you have at this point? And can you explain your thinking behind this investment?

Robert Koenigsberger: Luckily, we had no Russia or Ukraine, entering the invasion on the 24th, and quite frankly the scans were straightforward. We thought that unfortunately the likelihood of an invasion was pretty much a draw. And at the time, Ukrainian bonds were trading at 80 cents and Russian bonds were trading between 100 and 150. So we estimated that Ukraine had maybe 10 points up in the happy occasion without an invasion or can -be 50 or 60 drop. After the 24th we saw assets trading, bonds trading down to maybe under 20s/teenagers, which allowed us to establish an initial position in Ukraine and, quite frankly, d to be very dynamic with this position. Because we expect that on the other side of this conflict, yes, there will be a very strong and well-westernly supported Ukraine, but I also hope and expect that the holders of bonds share the burden and recovery. And we’ve come up with this concept of a Ukrainian stimulus bond that can help ease the return to the financial markets for Ukraine eventually.

Picker: What do you think of the school of thought, however, that says to avoid Ukrainian bonds, because of the risk that Ukraine will effectively become part of Russia, rendering that debt essentially worthless?

Koenigsberger: There is certainly this notion and let’s hope it doesn’t become part of Russia, but we have a long history of countries that no longer exist, but whose stock of debt remains. A couple comes to mind – Yugoslavia, long ago. Yugoslavia did not exist, but its stock of debt was recovered by the republics which emerged from it. And while we’re talking about Russia, the Soviet Union failed, ceased to exist, but its stock of debt was still honored in a debt restructuring in 1999 and 2000… Our base case scenario is that Ukraine will continue to exist. We don’t think it will be absorbed by Russia. It will continue to have a stock of debt, it will continue to have much of the assets and the capacity to service debt that it has today. Sure, it will take them a long time to rebuild that, but I wouldn’t say that the outstanding debt is worthless.

Picker: What about the outstanding debt in Russia today? Have you tried to trade this either long side or short side? Do you have a position there?

Koenigsberger: We are absolutely not involved in Russia. We weren’t involved for months before the invasion. Once the risk of invasion becomes something with substantial weight, just risk-reward, the asymmetry just doesn’t make sense. You know, after the invasion, Russia 2022 is very different from Russia in 1998-99. After this default, much of the pain Russia suffered at the time was not necessarily self-inflicted. Much of the pain today is obviously self-inflicted. But let’s think about it, bottom up and top down why Russian debt doesn’t make sense here. From the bottom up we’re still hearing from clients this notion of self-imposed boycotts or sanctions, I think it’s still very early in the game technically, in terms of how much supply is going to be sold by ETFs and mutual and long-term funds [unintelligible] emerging market bond investors at a time when the pipes are broken. And what I mean by that is that the banks go out of business, the pipes to fix the problem – Euroclear, DTC, etc. – do not settle. So even if you want to trade, it will become difficult. So quite frankly I see a bit of a bottom-up tsunami coming where there’s an inelastic supply that holders are being asked to stop holding in a world where it’s hard to get rid of holding, which should mean a drop in prices.

And then, top to bottom, what will Russia look like “the day after?” And I think you have to go back and look at how unstable Russia was between the fall of the wall in the early 90s and the consolidation of power by Vladimir Putin later in the decade. It was very nerve-wracking to have to figure out who was going to consolidate power, what that was going to mean. And I remember, for example, in the old days, when Yeltsin was president, I would get calls from our negotiating office, and they would say, ‘Boris Yeltsin is in the hospital,’ and we had to sort out why he was there. hospital, because one hospital was for sobering up and the other was the heart hospital. And if it was the heart hospital, we really had to worry about what that meant for the power on the other side of Yeltsin. And unfortunately, I think that’s where we are today. I mean, many are just saying the solution to Russia is that Putin is gone. But with the end of Putin would become the beginning of what? And so I think from top to bottom, there are also a lot of challenges to think about Russian debt.

Picker: In your opinion, what is the probability at this stage of a definitive default, by April 15?

Koenigsberger: So default is usually about someone’s ability and willingness to pay. Certainly, in the case of Russia, they indicate a willingness to pay, but a lack of capacity or capabilities. And this ability is not necessarily due to the fact that they do not have the financial resources. This capacity is due to the fact that technically it will be very difficult for them to pay… It is not very different from Argentina, when a long time ago, when Cristina Kirchner put, I think, almost a billion dollars in the Bank of New York, but since a court had told the Bank of New York, “You can’t afford that for bondholders,” it became known as a technical default. So I think it’s very likely that you will see a default in Russia whether they try to pay or not.

Picker: Do you think it will be painful, that it will choke the Russian economy if it defaults or do you think they weren’t really planning to access foreign markets to get into debt anyway? Their indebtedness compared to other countries, their size is relatively small, only 20 billion dollars of foreign currency debt at this stage. So is it even so monumental for them from a sanctions standpoint?

Koenigsberger: I don’t think debt and isolation are so monumental. Russia will suffer profound economic consequences. The speed and depth of these sanctions are unprecedented. And putting aside the outstanding debt, I don’t really think whether they pay or not, it will make a difference as to whether Russia is not an isolated economy, which is different from 1998-99. When they had the default at the time, it was thought that eventually Russia would want to access the capital markets again, that the default is the problem itself and so they are going to have to solve it very quickly in order to gain market access. And in fact, that’s what happened. In 12-13 months, they restructured Vneshekonombank loans which then became Russian Federation bonds and they were able to access the markets. Whether or not they pay this week, whether they pay the April deadline, will not give them access to the markets and it will not solve the disastrous economic consequences that this economy will suffer.

Picker: What do you see as the broader implications for emerging markets? India, China [are] Russia’s main trading partners, so one would assume that if their economy suffers, it could have repercussions in other emerging markets, obviously, Europe and the United States as well. But I’m particularly interested in places that fall into this category of emerging markets that you studied.

Koenigsberger: In the case of the Russian-Ukrainian conflict, the impact on the oil market, I mean, immediately you can start seeing winners and losers in emerging markets. And emerging markets are still considered a commodity asset class. Well, some places like Mexico export oil. Some places like Turkey import energy. So it’s hard to make a general statement about what it’s going to mean. That being said, I believe that the events of February 24 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 invasion. Perhaps there was going to be an incursion into eastern Ukraine. But it took everyone by surprise and so the ripple effect will probably surprise people. And I think part of the challenge here is the cumulative effect, right? I mean, we just went through a global pandemic and now we’re tackling this war in Ukraine, and its ripple effects.

Picker: Not to mention that there are already inflationary pressures, with central banks raising interest rates, which has historically impacted emerging markets. Given the complicated macroeconomic backdrop, where do you see this playing out? Who are the winners and who are the losers?

Koenigsberger: You start with oil, you start with commodities, you try to figure out which side a country or a company might be on. One of the other things that may be less obvious is this notion that – and this is a general statement, which I usually don’t like to make, but – COVID and this crisis are going to be a greater challenge for sovereigns and their balance than it may be for businesses. So once they understand the investment implications, sovereigns might be more at risk, corporates might be a safer place, much like last year when we saw that high yielding corporates emerging markets outperformed sovereigns. It was for a different reason, because of higher interest rates leading to lower prices. But imagine a ruler who makes the following decision: “Do we pass the prices on to our society which cannot afford these prices when it comes to food? Or do we subsidize that?” And I think the choice will be that they will subsidize to try to reduce the impact for their societies. Well, in doing so, much like we’ve seen with developed market balance sheets, it’s going to put pressure on those balance sheets that didn’t exist before from a debt perspective, debt to GDP , debt sustainability. So that’s definitely one of the things to watch out for here.

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