Russian domestic bonds come of age

Just a few years ago, the Russian domestic fixed income market was seen as an obscure, difficult and highly risky place to invest — a pet project of the EBRD, but one with an uncertain outcome as it was feared that the Russian government had little inclination to put in place reforms.

Fast forward to June 2013 and the market has developed to the point of being almost unrecognisable. The volume of paper outstanding has grown to more than $200bn-equivalent. And there is pressure on it to grow further, from issuers and investors. 

In 2007 many domestic market issuers were eager to break into printing dollar bonds to take advantage of lower funding costs and the prestige of accessing an international market. But since the financial crisis, borrowers are much more focused on matching the currency of their assets with that of their liabilities. Domestic documentation is a lot easier too.

As a result, foreign investors wanting exposure to certain industries in Russia must now venture into the domestic market rather than waiting for borrowers to print in dollars.

Unusually for an EM country, the pressure on the local market to grow is being matched by the pace of reform. This year the market has already started to shake off its most restrictive shackle: OFZs, Russian government debt, became Euroclearable in February. And later this year the country is set to release its entire domestic market when it does the same for its corporate and bank bonds — once the remaining questions over disclosure and taxation for foreign nominees have been resolved.

The changes mean that foreigners can now buy domestic Russian bonds much more easily and without the need for local brokerage accounts. Inflows have already surged: some $9bn entered the market in 2012 in anticipation of the change, and analysts reckon that up to $40bn of new money will be put to work there this year. Fixed income trading volumes on the Moscow Exchange doubled in the first quarter of 2013.

Foreign investors now own about a fifth of OFZs, compared to a meagre 3% before the introduction of Euroclear. If global rates remain low, Russian domestic bonds could increasingly be seen as an attractive high yielding alternative investment. 

“Eurocleability has been a success on the OFZ market and the proportion of international investors has definitely increased, so there’s no logical reason why the same won’t happen now for corporates,” says Andrey Solovyev, head of global DCM at VTB Capital Moscow.

Vladimir Potapov, CEO of VTB Investment Management, a firm that manages over $3bn in Russian fixed income, is looking forward to a tighening of corporate spreads.

“The current spread of tier one corporates to OFZs isn’t justified, it’s more a function of liquidity,” he says. “We made a lot of money holding Russian government paper as that market became Euroclearable and hope to do same rotating the strategy to the corporate side.” 

Nonetheless, analysts argue that the tightening of domestic corporate and bank spreads will not be so marked as it was in OFZs. Tier one corporates currently trade at around 160bp-200bp over OFZs.

“We’re expecting some appreciation in prices as corporate Euroclearability is introduced but we only expect that spread to narrow to 120bp-150bp over OFZs, so a tightening of up to 50bp,” says Denis Poryvay, an analyst at Raffeisenbank International in Moscow. “OFZs have rallied by more than 100bp over the course of the last year, to yield less than 7%.” 

Poryvay says this is because the foreign demand in the domestic market is largely driven by the outlook for rouble exchange rates and rouble interest rates rather than by credit risk, which is why there is naturally much more international interest in government bonds than the corporate sector. 

“If international investors want to play the credit risk, there’s plenty of opportunity in the Eurobond market,” he says.

But Euroclearability is not the only turbo boost expected for the domestic corporate market in the near future. Russia is planning to scrap a law that requires the country’s pension funds to return positive growth every year, Alexei Moiseev, the country’s deputy finance minister told EuroWeek earlier this year. The state also plans to limit investors’ ability to switch funds in a bid to increase stability. 

Because at the moment pension funds must show positive returns every year, they are only comfortable investing in government bonds and keeping their funds in deposits. At the end of 2012, Russian pension funds had $90bn-$100bn of assets under management. The loosening of the annual no-loss law means that the scope of investment for these funds will be much broader and both the equity market and corporate and bank bond market should benefit. 

Pension fund money tends to add stability to a market and a longer term of investment, meaning that longer maturities and different types of instrument can be printed.

“The pension fund reform will have a very strong impact on the market,” says Solovyev. “There’ll be much more of a need to have longer dated instruments. There were domestic CPI-linked bonds last year from Russian Railways and Rusnano and they act as a good hedge for those companies. 

“There will be more of these and the Russian pension funds will be natural buyers of those to beat inflation. There’s a lot of international interest too in this kind of note, which when the domestic corporate market becomes Euroclearable will also become involved.”

Potapov agrees, saying that Russian pension fund money will be a big driver of domestic debt over the next few years. By 2020, he expects the local pension funds to have $400bn to deploy. 

But the boost to the rouble corporate bonds may come at the expense of simultaneous pressure on OFZs.

“Pension fund reform in Russia is decreasing pension money inflow to the State Trust Management Company (VEB), which is the core holder of OFZs, in favour of private asset management companies, which prefer investing into corporate bonds as they offer higher yields,” says Poryvay. “So we expect VEB to show low demand for OFZs this year and later. The fact that long-dated OFZs are trading flat with CPI does support interest from local players.”

The domestic market is deepening and could eventually offer maturities and yields comparable with the international bond market. But the market is still growing and the maturities and sizes that the international rouble bond market offers are at the moment much bigger than the domestic market. 

The domestic market mostly offers three to five year financing, which is unsuitable for the funding of companies’ longer plans such as infrastructure projects. And those are some of the biggest deals in the Eurorouble market, from the likes of Russian Railways. 

Brunswick Rail priced its debut $600m Eurobond last year but is this year looking for rouble-denominated bond financing as it seeks to increase its fleet either via an M&A transaction or through organic growth. 

“Longer term we need roubles for the sake of currency management as any potential M&A transaction would take place in roubles, although in the short term we can finance it through a bridge to bond in dollars,” says Nicolas Pascault, CFO of Brunswick Rail. “The targets we are talking to have rouble contracts. Whether we use the domestic market or the Eurorouble market to refinance any acquisition package will probably depend on what maturity we need. 

“We’d perhaps do Euroroubles as that offers longer maturities. We will make the decision based on pricing, maturity and liquidity.”

Pascault adds that even if the company doesn’t go through with an acquisition, it has an increasing need for roubles and wants to raise more money in that currency to gain more flexibility and balance its assets and liabilities. 

But even as the domestic market grows, bankers say they do not see an imminent end to the Eurorouble market because of differences in the laws that govern the two. 

“There’s still an arbitrage between domestic and Eurorouble issues, and I expect that spread to remain because of the differences in enforceability between Russian law and English law,” says Solovyev. “If something goes wrong, do you want the dispute settled in Russian courts or UK courts? Some investors have a strong view on this.” 

But though some more cautious international investors may still cling to the Eurorouble format, domestic investors see no need for it in the longer term, once there is good liquidity and a varied investor base locally.

“We’re comfortable with domestic debt and Russian law, so for us the difference between the international market and the domestic market is mostly about taxes, convenience of holding the paper, liquidity and pricing,” says an emerging markets fund manager based in Russia. 

“If the yields and the infrastructure for holding Eurorouble debt is the same as for domestic debt, there’s no need for the extra layer of difficulty of issuing Eurorouble paper. It is logical for the markets to converge on to the local market rather than having two separate markets for rouble paper.”

As part of the liberalisation of the Russian domestic bond market, it is now also easier for foreign companies to issue in it and take advantage of that pool of liquidity. 

A European issuer can now simply translate its EMTN documentation into Russian to use with domestic Russian investors — avoiding the complex process it had to deal with before in order to access rouble liquidity for Russian operations. Société Générale is one bank that says it has a queue of these deals now ready to be executed and is expecting to bring at least a couple this year.

The global financial crisis has undoubtedly strengthened the appeal of the Russian domestic bond market. But despite the euphoria, stumbling blocks remain.

Anticipation of Euroclearability played a part in the rally in OFZs in 2012, but so did quantitative easing in the US. Real interest rates in the Russian domestic market were high, so a lot of speculative money flowed into the local market to pick up a higher yield. 

No further tightening is expected in the short term for OFZs and, should US Treasury rates continue to rise, there could even be a reversal. 

The domestic fixed income market will also be driven by Central Bank of Russia policy and, specifically, whether it decides to cut interest rates if inflation falls. 

“We’re anticipating a 50bp rate cut, and there will undoubtedly be a response in the local market if that happens,” says Poryvay. “We’re also keeping an eye on oil prices, which could still fall because of the global slowdown and that would have a negative reaction on the trading of OFZs. 

“But our base scenario for oil prices is that the drop will happen but it won’t be significant — the price will stay between $90-$100 a barrel.”