LONDON/MOSCOW: Unable to raise capital via Eurobonds, Russia will have no trouble luring investors to its fallback option of selling more local debt but its failure to build a domestic investor base may impact longer-term strategy.
Russia had hoped to raise up to $3 billion via foreign borrowing this year. But its Eurobond plans were stymied by US
regulators who lobbied banks and big funds to shun the issue because its proceeds could, in theory, be used to fund entities sanctioned by the West for their role in the Ukraine crisis.
The $3 billion sum may instead be raised via OFZ — local bonds denominated in roubles — adding to the 800 billion rouble ($12.22 billion) issuance originally planned for 2016.
OFZ issuance is predicted to rise sharply because of the need to fund budget spending before 2018 elections.
There are positives to this.
By scrapping Eurobonds, Russia will protect its already low external debt ratios. It will also avoid digging further into its precious rainy-day savings funds which have dwindled to $125 billion from mid-2014 peaks above $180 billion.
Any extra OFZ supply should be quickly snapped up by local banks keen on high-yielding government securities and by foreign fund managers boosting exposure to a market they fled in panic two years ago.
“The structural case for being long rates in Russia is pretty good,” said Rob Drijkoningen, co-head of emerging debt at asset manager Neuberger Bermann.
“Clearly, there is a disinflation path ahead and if they can start cutting rates it will be a very big plus for local (bonds) to continue rallying.” Oil’s recent rally has already made Russia this year’s best performing emerging bond market, with dollar-based returns of over 15 per cent, compared with 13 per cent on the underlying GBI-EM index run by JPMorgan.
JPM predicts 26 per cent full-year returns in Russia.
Moreover, stronger oil means rouble exposure is less of a risk; JPM reckons the currency is 6 per cent too cheap and should rise further against the dollar.
With the rouble having firmed 30 per cent since mid-January and inflation less than half year-ago levels, investors are betting on interest rate cuts. Ten-year yields fell under 9 per cent on Friday for the first time since mid-2014 after the central bank held interest rates unchanged but hinted they could fall.
The bank has earned investors’ respect by staying focused on inflation targets and being slow to ease policy even in the face of a brutal recession.
David Hauner, head of EEMEA debt and strategy at Bank of America Merrill Lynch (BAML), sees Russia as potentially the most lucrative emerging debt trade. Russia’s three-month inflation run-rate has fallen to 3 per cent, he estimates.
“If this proves sustainable, rates have a lot of downside.
We forecast 400 bps in cuts over 12 months versus less than 200 bps priced in. They are patient now to bring down inflation expectations, but the cutting cycle will ultimately be long and deep,” Hauner said.
While foreigners own just 21 per cent of Russia’s bond market, he expects this to rise back towards mid-2013 peaks around 28 per cent this year despite increased issuance.
YIELDS On the other hand, Russia has deep-seated problems: Western sanctions, reliance on commodity revenues and, above all, a government reluctant to implement even basic economic reforms.
With gross 2016 OFZ supply seen rising above 1 trillion roubles, yields should surge above 10 per cent rather than fall in line with inflation, Societe Generale predicted.
Official forecasts are for 800 billion roubles in issuance this year, rising to 1.2 trillion in 2017 and 2018 but these were made back in December. Most analysts see supply rising more.
“The current fiscal situation will lead Russia to print more OFZ ... we would rather see double-digit yields to make the investment more attractive,” said Jean-Dominique Butikofer, head of emerging debt at Voya Investment Management.
Rising debt issuance will probably highlight Russia’s failure to develop its pension and insurance industry, a key component of capital market development.
In this respect, Russia scores far worse than most emerging economies, with pension assets equal to 6.5 per cent of annual GDP in early 2015, central bank data shows.
Comparable ratios in South Africa and South Korea are 60 and 40 per cent respectively, according to consultancy Towers Watson.
Typically, pension and insurance funds add liquidity and reduce market volatility while their need to match long-term returns to future commitments means they tend to buy long-dated debt, driving down yields.
BAML data shows domestic institutions’ demand for OFZ amounts to just 100-150 billion roubles a year, a fact that may return to haunt Russia if it needs to sharply expand bond sales.
Drijkoningen said the paucity of institutional buyers for long-dated bonds had left the Russian yield curve flat, while an economy in recession would usually have an inverted curve, where long yields are lower than those on short-dated bonds.
“The problem is there are not so many dedicated investors within Russia as they have failed to build a decent playing field for insurance and pension funds so natural demand for rouble bonds only goes so far,” he added.
