Behind the fight over whether Russia should be allowed to pay off its debts is an age-old issue: Borrowers, even in times of war, want to keep their reputations for making investors whole.

The U.S. Treasury Department this week blocked Russia from paying off a bond it had due on Monday by denying a sanctions waiver to JPMorgan Chase & Co. to process the transfer. The Treasury said U.S. banks would no longer be allowed to facilitate payments, but implied Russia could find other means, possibly using non-U.S. banks.

Russia…

Behind the fight over whether Russia should be allowed to pay off its debts is an age-old issue: Borrowers, even in times of war, want to keep their reputations for making investors whole.

The U.S. Treasury Department this week blocked Russia from paying off a bond it had due on Monday by denying a sanctions waiver to
JPMorgan Chase & Co.
to process the transfer. The Treasury said U.S. banks would no longer be allowed to facilitate payments, but implied Russia could find other means, possibly using non-U.S. banks.

Russia responded by saying it would pay off investors with rubles instead, delivered to accounts inside Russia. Doing so isn’t allowed under the rules of the bond, but it shows Russia’s determination not to leave bondholders completely empty-handed. Russia’s finance ministry said it considered its obligations fulfilled, though the bond has a 30-day grace period, so Russia has time to switch the payments to dollars.

While war in Ukraine rages and the West unveils a fresh round of harsh sanctions, Moscow remains steadfast that it wants to avoid the unpleasant distinction of failing to pay its debts. It last defaulted on local currency bonds in 1998, and it took several years of painful economic reforms to get back in the good graces of international investors. The country hasn’t defaulted on foreign debt since the wake of the communist revolution in 1918, when Vladimir Lenin repudiated the Russian Empire’s borrowings.

“Russia has proven they don’t want to default. It would be very damaging long-term,” said Timothy Ash, an emerging-markets strategist at BlueBay Asset Management.

Though Russia’s reintegration into the global financial system is hard to imagine at the moment, the country’s leaders may want to point back years from now and say Russia did what it could to pay investors through troubled times.

Unlike previous defaults, Russia has plenty of money to pay off its debts, with $600 billion of foreign currency reserves and billions of dollars in new revenue each week from sales of oil and gas that continue thanks to exceptions written into sanctions policy. But U.S. and European sanctions on Russia’s central bank and finance ministry have hemmed in what it can do with the money.

An official default on its debt would have a limited immediate impact on Russia’s economy since the country is already cut off from international markets by the sanctions.

Before the invasion, Russia had an investment-grade credit rating from all three major rating companies. Last month, S&P Global,
Moody’s
and Fitch all downgraded it to junk status, warning that the risk of investors not being repaid was high. Then they withdrew their ratings, part of the exodus of companies ceasing operations in the country.

SHARE YOUR THOUGHTS

Do you think Russia could ever default? Why or why not? Join the conversation below.

Russia’s dollar bond maturing in 2042 traded at 25 cents on the dollar on Wednesday, down from 98 cents the day before Ukraine was invaded, according to AdvantageData, a level normally associated with default.

“There’s going to be issues paying dollars, unless Putin flies to New York and hands out gold bars to investors,” Mr. Ash said.

Russia has two broad flavors of bonds held by foreigners: local currency bonds issued in rubles inside Russia, and foreign currency bonds, issued in dollars and euros and traded internationally.

If it fails to make the payments on the dollar bonds, investors would likely declare Russia in default when the grace period ends and seek to get their money back in English courts, where the bonds are governed. The process could take years and investors would be betting on an eventual thaw in relations.

Russia has continued to pay on the ruble bonds, but for over a month it has blocked the payments going to foreign investors, who hold under a fifth of the bonds. The move was a retaliation against Western sanctions.

One class of investors not getting paid would normally constitute a default. But those bonds are governed by Russian law, which may be on the government’s side to avoid technically earning the default distinction.

Russia changed a federal securities law in late 2018 to so that an issuer of local debt no longer has to ensure payments reach investors. The borrower’s obligations are met if the money arrives at the clearing system, a piece of financial infrastructure that helps process money flows. This is similar to how bond payments work under English law.

The consequences of harsh economic sanctions against Russia are already being felt across the globe. WSJ’s Greg Ip joins other experts to explain the significance of what has happened so far and how the conflict might transform the global economy. Photo Illustration: Alexander Hotz

“As long as you have paid the clearing system, you have fulfilled your end of the bargain,” said Tamer Amara, a partner at law firm Dentons with a focus on Russian capital markets. Lawyers at other firms with a presence in Moscow and U.S.-based bondholders have arrived at similar conclusions.

Records show that the Ministry of Finance sent the interest payment on a ruble bond due on March 2 to the system, the National Settlement Depository, on time. Foreign investors, however, have yet to receive the 22 billion rubles, equivalent to $270 million, because Russia’s central bank blocked the transfer.

Some foreign investors may not have been aware of the new rules: The Russian central bank has an old copy of the federal securities law on the English version of its website. The central bank didn’t immediately respond to a request for comment.

The securities law could make suing for payment under Russian law, already a difficult prospect, even more daunting.

Viktor Szabo, an investment director with a focus on emerging-market debt at Abrdn, said his team wrote the value of its local-currency Russian government bonds down to zero. They are holding on to the bonds for the moment in hopes that they will be able to sell in the future for higher prices than the market currently offers.

“We’re assuming that at some point this will be resolved,” he said. “The money is there so there should be some value, but it just takes time and a lot of patience.”

Write to Anna Hirtenstein at anna.hirtenstein@wsj.com and Caitlin Ostroff at caitlin.ostroff@wsj.com