Amid the Russia-Ukraine conflict, Gramercy Funds CIO discusses emerging markets investing, particularly Ukrainian bonds.

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Since the ongoing Russia-Ukraine conflict, emerging markets, particularly those in Eastern Europe, have been affected. With sanctions in place and Russia's hard default deadline approaching in April, investors are closely monitoring the region's sovereign debt. Gramercy Funds, which has specialized in this area since its inception in 1998, is particularly focused on this issue.

Robert Koenigsberger, CIO of a $5.5 billion investment firm, discussed his investment in Ukrainian bonds and why a 2022 Russian default would be very different from the country's financial crisis in 1998 with CNBC's Delivering Alpha newsletter.

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What is the amount of Ukrainian bonds you currently own, and what was the reasoning behind this investment decision?

On the 24th, we entered the conflict with no ownership of Russia or Ukraine. Our analytics were straightforward; we believed that the probability of an invasion was a coin toss. At the time, Ukrainian bonds were trading at 80 cents, and Russian bonds were trading between 100 and 150 cents. We thought that Ukraine had a 10-point upside in the event of no invasion or a 50-60-point downside. After the 24th, we saw assets and bonds trade as low as the low 20s/high teens. This allowed us to establish an initial position in Ukraine and be dynamic with that position. We expect that, after the conflict, Ukraine will be well-supported by the West, and bondholders will share the burden and recovery. We have developed a concept of a Ukrainian recovery bond that can help Ukraine re-enter the financial markets.

What is your opinion on the school of thought that advises against investing in Ukrainian bonds due to the possibility that Ukraine may become part of Russia, which would render the debt valueless?

Koenigsberger: We hope that the notion of Ukraine being absorbed by Russia does not become a reality, but we have a history of countries that no longer exist but their debt stocks remain. For example, Yugoslavia failed to exist, but its debt stock was taken up by the subsequent republics that emerged from it. Similarly, the Soviet Union failed and ceased to exist, but its debt stock was honored in a debt restructuring in 1999 and 2000. Our base case is that Ukraine will continue to exist and not be absorbed by Russia. It will have a debt stock and a vast portion of the assets and debt service capability that it has today. Although it will take time for them to rebuild, the debt stock is not worthless.

Have you been attempting to trade Russia's debt stock, either long or short, and do you currently hold a position in it?

Koenigsberger: We were completely uninvolved in Russia before the invasion. However, once the invasion risk became substantial, we realized that the asymmetry didn't make sense. Post-invasion, Russia 2022 is vastly different from Russia in 1998-99. After the default, a lot of the pain that Russia suffered back then wasn't entirely self-inflicted. However, a lot of the pain today is self-inflicted. Let's consider the bottom-up and top-down reasons why Russian debt doesn't make sense. Bottoms up, we're still hearing from clients about self-imposed boycotts or sanctions, which is still in its early stages. In terms of the amount of supply that will be sold by ETFs and mutual funds and long-emerging market debt investors at a time when the pipes are broken. The banks are ceasing trading, and the pipes to settle it, such as Euroclear and DTC, are not settling. Even if you want to trade, it will become difficult. Therefore, I see a bottom-up tsunami coming where there is inelastic supply

What will Russia look like "the day after" Putin's departure? One must reflect on Russia's instability during the period from the fall of the Berlin Wall in the early 90s to Putin's consolidation of power later that decade. It was a nerve-wracking time as we tried to determine who would seize power and what that would mean. For example, when Yeltsin was president, we received calls from our trading desk informing us of his hospitalization, and we had to triage the reason for his hospitalization, as one hospital was for sobering up and the other was for cardiac care. If it was the cardiac hospital, we had to be concerned about the impact on power on the other side of Yeltsin. Unfortunately, we are in a similar situation today, and many believe that the solution to Russia's problems is for Putin to step down. However, with the end of Putin, what will become of Russia's debt? There are many challenges to consider when thinking about Russia's future.

What is the probability of a hard default occurring by April 15?

Koenigsberger: A default is typically about a person's ability and willingness to pay. In Russia's case, they are indicating a willingness but a lack of capacity or capability. This capability is not due to a lack of financial resources, but rather because it is technically challenging for them to pay. This is similar to Argentina's situation when Cristina Kirchner deposited nearly a billion dollars in the Bank of New York, which was later deemed a technical default due to a court's ruling that the bank could not afford it to bondholders. As a result, it is likely that Russia will default, regardless of whether they try to pay or not.

Will a default by Russia lead to economic choking, or were they not planning to access foreign markets for debt? Although their debt load is relatively small, only $20 billion in foreign currency debt, the impact of sanctions may not be significant.

Koenigsberger: I believe the debt and isolation are not as significant as they are being portrayed. Russia will face severe economic consequences due to the unprecedented velocity and depth of these sanctions. While the payment of debt may not make a difference in Russia's isolation, it is essential to address the underlying economic issues. In 1998-99, Russia defaulted on its debt, which led to a quick resolution to access the capital markets. However, this week's payment of the April maturity will not solve the dire economic consequences that Russia is facing.

What are the broader implications for emerging markets, particularly those that are major trading partners for Russia, such as India and China? If their economies are affected, it could have ripple effects on other emerging markets, including Europe and the U.S. I would like to focus specifically on these emerging markets that you have studied.

The Russia-Ukraine conflict has an immediate impact on the oil market, with winners and losers emerging within emerging markets. EM is always considered a commodity asset class, with some places like Mexico exporting oil and others like Turkey importing energy. However, it is challenging to make a blanket statement about the impact of the conflict on the oil market. The events of February 24th took the world by surprise, with an invasion of Ukraine that was not part of anyone's base case. The ripple effect of this surprise invasion is likely to catch people off guard, and the cumulative effect of this event, following the global pandemic, is a significant challenge.

Inflationary pressure and central banks raising interest rates have historically affected emerging markets. Given the complex macroeconomic environment, how do you envision this playing out? Which groups will benefit and which will suffer?

Sovereigns may face a bigger challenge in managing their balance sheets during the COVID crisis compared to corporations. This is because they have to make decisions about passing through prices to their societies or subsidizing them to lessen the impact. However, subsidizing may put stress on their balance sheets from a debt perspective, debt to GDP perspective, and debt sustainability perspective.