Should Investors Who Care About ESG Buy Russian Sovereign Bonds?

Mark Weidemaier and Mitu Gulati

Umm... no?

We can think of two models of ESG investing. (At Bloomberg, Matt Levine has a more sophisticated take; also here.) One is normative, simple, and apparently held by very few investors. It goes something like, don’t invest in “bad” activities or borrowers. A second model, apparently more common, is that investors rely on ESG metrics to inform them about potential risks and economic implications of a borrower’s ESG-related practices. As Sustainalytics puts it, “Material ESG issues (MEIs) are business issues related to environmental, social, and governance factors that may have a measurable impact on financial performance.” We confess that we don’t really understand this second model, or how it differs from an investment approach that puts risk-adjusted returns above all else. But it seems to make people feel good.

Anyway, you probably were not wondering about the link between Russian sovereign debt and ESG investing. Neither were we, because, well, why would anyone wonder about that? It seems obvious that investors buy Russian sovereign debt specifically because they do not care about ESG goals, at least for purposes of that investment. The ESG part of the investor’s brain is off doing something else while the part that chases yield buys Russian bonds. But most investors claim to care about ESG goals. And some people seem to be wondering what it means that investors who make this claim sometimes hold Russian bonds too. One way to understand this fact is to posit a flaw in ESG metrics. As the Financial Times summarizes one expert in sustainable finance, “Russia’s invasion of Ukraine has exposed the failings of asset managers and data analytics firms in their assessment of environmental, social and governance risks.” An implication is that “ESG data firms need to look at [the war in Ukraine] and ask themselves what they have missed.”

Another way to put the problem is to say that what ESG data firms have missed is that investors do not care about ESG. Yet a third way to put it is to say that investors cannot be bothered to read contracts, so you can get them to agree to the most outrageous things if you just have the chutzpah to write it down and hope they don't notice. The Russian sovereign bonds nicely illustrate both of these latter possibilities.

Consider the Alternative Payment Currency Event clause in a subset of Russia’s international bonds. As we have written here before, and discussed on Clauses and Controversies (here and here), these clauses let the Russian government pay in another currency if, “for reasons beyond its control,” it can’t come up with the currency specified for repayment. In a euro bond, for example, the alternative currencies are US dollars, Pound sterling or Swiss francs. But if one of these currencies isn’t available—again, “for reasons beyond its control”—the Russian Federation can pay in rubles. The Russian government appears to take the position that the sanctions imposed by the US and other governments have triggered this clause, allowing it to pay rubles to holders of bonds denominated in USD or euros. Investors are shocked...shocked!...at this interpretation.

They shouldn’t be. We think there is a reasonable probability that a court in London or New York would reject the Russian interpretation. (ISDA's Determinations Committee has just considered the treatment of the bonds for CDS purposes.) But the interpretation is more than plausible. Indeed, one way to understand this subset of the Russian bonds is that they express a quite simple, straightforward idea: Investors assume the risk of sanctions. Or, to put it a bit differently, investors implicitly agree to finance misbehavior by the Russian government.

We suspect most investors would vehemently protest this characterization. And we accept that this is in good faith. But it’s hard to know what to make of these protestations in light of the disclosures that accompany Russia’s sovereign bonds. For example, the November 18, 2020 prospectus for euro-denominated bonds due 2027 and 2032 includes nearly 7 pages of risk disclosures related to existing and potential sanctions. It is a collection of Putin’s greatest hits—all of the activities that have led to the imposition of sanctions and might lead to even more sanctions in the future. There are old classics, like how, in March 2014, “following mass protests and a change of government in Ukraine, the citizens of Crimea voted by referendum to join the Russian Federation.” (You may remember events a bit differently.) And the one about how “armed conflicts arose in the Eastern part of Ukraine, resulting in the creation by citizens of the Donetsk People’s Republic (“DPR”) and the Lugansk People’s Republic (“LPR”).” And surely you recall the “alleged violation of international law in connection with a nerve gas incident in the United Kingdom.”

For the slow-witted, the prospectus also points out that events like these have already led to sanctions against the Russian government and its sovereign debt and might lead to more sanctions in the future: “[C]ontinued geopolitical tensions, particularly if they were to result in additional sanctions (including those relating to Russian sovereign debt) and retaliatory measures, could have a material adverse impact on the Russian Federation's economy, the economies of the other countries involved, global economic conditions and the trading price of the Bonds.” For the especially slow-witted, the risk factors point out that sanctions and related geopolitical tension have caused the ruble to depreciate and that further depreciation might “adversely affect ... the Russian Federation's ability to repay its debt denominated in currencies other than the rouble, including amounts due under the Bonds.” (See pages 11-17 for the quotes.)

Given these disclosures, it is no wonder that Russia asserts the right to pay in rubles. “Look,” the Russians say, “we told you we might do more stuff that got us sanctioned and that sanctions might affect our ability to pay you in hard currency, and you agreed that we could pay you in rubles if that happened.” If we just view the bonds as a contract—instead of a document that implicates a broader geopolitical conflict—this is a pretty plausible view. Again, it would not surprise us if a tribunal rejected it, largely because the contract, read the way Russia suggests, is pretty despicable. As we say above, it effectively provides for investors to fund Russian misbehavior.

Against this backdrop, it seems a bit of a non-sequitur to say that investors are not adequately taking ESG goals into account. They aren’t! But that’s kind of an indirect way to state the problem. The problem is (i) that investors arguably have assumed the risk that a previously-sanctioned, authoritarian regime will be subject to additional sanctions and (ii) that many investors didn’t know they had done this until the Russians pointed it out. Sure, ESG data firms should update their ESG metrics. But please, someone, read the contracts.