The global liquidity squeeze has sapped many investors appetite for riskier emerging market credits. As pricing hierarchy returns, top Russian borrowers with compelling stories will be the only ones willing or able to price deals unless conditions improve. Joanne OConnor reports.
It is a cliché, but for Russian borrowers, 2007 has been a year of two halves. From gorging themselves in the international bond market in the first half of the year with almost $27.2bn of issuance including securitisations more than the $24bn issued in the whole of 2006 Russian borrowers are facing a lean run-up to the end of the year.
"If you look at new issuance numbers for the first half of the year, it was an extremely strong six months and pre-crisis issuance volume was higher than for the whole of 2006," says Mike Elliff, managing director at ABN Amro in London.
The year started promisingly, with $9.6bn of new international public issues, including securitisations, in the first quarter, and a staggering $17.6bn in the second. Amid this issuance frenzy, accessing new investors became the chief aim, and after a series of successful sterling deals by Kazakh banks, VTB, Russias second largest bank, became the first Russian entity to issue in sterling. In early March, it priced £300m of three year paper at an aggressive 70bp over mid-swaps, nearly 10bp inside VTBs Russian curve.
Meanwhile, Russian Agricultural Bank in the same month sampled the notoriously conservative Swiss franc market, pricing Sfr375m of three year paper, almost double the originally planned size, and inside price talk. Bankers spoke optimistically of Russian issuance in yen, Hong Kong dollars, Australian dollars and South African rand. And companies such as Novorossiysk Commercial Sea Port, car distributor Rolf Group, coal company Kuzbassrazrezugol and rail and transportation group Severstaltrans delighted investors keen for diversity away from bank issuance.
In July, Russian Agricultural Bank followed up on its Swiss franc deal with Russias first ever first upper tier two financing. The $200m bilateral loan from ABN Amro was structured as a 10 year non-call five and, although a loan, was akin to a bond in structure. "The deal will pave the way for many more financings with structures like this one," says ABN Amros Elliff.
But in July, the merry-go-round abruptly stopped. Sparked by fears of the extent of exposure to the US subprime mortgage market, the interbank lending market froze and liquidity dried up. The result was that between August 8, when Gazprom priced a $1.25bn 30 year deal, and October 3, not a single international deal was priced and what was expected to be the busiest September ever for syndicate desks of Russian new debt issues was a wash-out.
In contrast to the catastrophe of 1998 when Russia staged the largest sovereign default ever this summer, when fears about the US subprime mortgage market crept into Russias domestic mortgage market, Russian bonds initially remained surprisingly resilient. But a few weeks after the initial panic struck, spreads were hit and the local bank lending market suffered a chronic bout of illiquidity.
After reaching an historic low of 80bp over Treasuries, the EMBI+ Russia bond index widened to 100bp over in mid-July and reached a peak of 140bp over in August before easing back to the 125bp level. The EMBI+ Global index as a whole spiked up to reach a peak of 226bp over Treasuries at the end of July, having reached an historic low spread of 150bp over in June. If emerging markets have outperformed other asset classes in the summer rout, Russia was one of the best in class. In August, Russian five year sovereign CDS reached 85bp compared with 40bp in June.
TNK-BP braves market after hiatus
In October, Baa2/BB+/BBB- rated oil company TNK-BP became the first Russian borrower to venture back into the market when it ambitiously priced $1.7bn of bonds through Credit Suisse and UBS. The deal comprised $600m of five year and $1.1bn of 10 year bonds, priced at 345bp and 350bp over Treasuries respectively, offering a new issue premium of around 30bp in line with that offered by similarly rated European and US companies. While the bonds widened initially in response to turmoil in the Kazakh banking sector, the deal quickly recovered.
Nonetheless, some observers away from the deal suggested its size was to blame for the widening in March, at the height of the bull market, TNK-BP printed a dual tranche deal comprising $500m of five year paper and just $800m of 10 year notes. These bonds were priced at 173bp and 223bp over Treasuries respectively, a big discount to Octobers prices.
The deal had the sort of rapid-fire execution that bankers expect will become a common feature of this fragile market. Investors that dont need to roadshow will not do so, and when windows present themselves, borrowers will execute swiftly. And if there was one message from TNK-BPs foray into the new issue market, it was that every deal must stand on its own merits.
"This is not a binary market the notion of re-opening the market is irrelevant," says Simonas Eimaitis, director of syndicate at UBS in London. "Individual issuers will have to look at the market on a case-by-case basis and take advantage of windows of opportunity to do deals. Our window of opportunity presented itself on Tuesday, but on Wednesday, the market turned against us. TNK re-opened the market for TNK. Everyone else is on their own."
ABN Amros Elliff says: "The market has now re-opened for corporate borrowers with a good story that are prepared to pay a premium for funding. These corporates do not have to be investment grade, as has been seen in the recent TGI deal from Colombia, but they do need to have a good credit story."
Among these borrowers, Rosneft and Evraz are both said to be planning deals, as are the state owned banks VTB and Sberbank. Gazprom Russias most prolific corporate borrower also tapped the market in October. "Corporates likely to brave the current market will include those who require funding for M&A events, or the more frequent corporate issuers like Gazprom or TNK-BP who are looking quite sensibly to maintain a regular funding programme." Elliff adds.
Accepting the new pricing paradigm
Some Russian borrowers have earned themselves a reputation for inflexibility and have adopted an almost irrational drive towards ever-tighter pricing, regardless of market conditions. In February, pipeline company Transneft priced its debut bond flat to Russian sovereign credit default swaps. Priced at 55bp over mid-swaps, through bookrunners Credit Suisse and Goldman Sachs, the $1.3bn seven year bond widened out to 80bp over.
The borrower insisted its status as a debt-free 100% state owned and strategically vital company gave it double-A rated metrics, despite its A2/BBB+ credit rating.
When Transneft returned in June, it was with a dual tranche Eu700m and $500m five year issue. Citigroup, Goldman Sachs and UBS priced the notes at a generous but realistic 60bp over mid-swaps, or 20bp back of Russian CDS.
In July, Rosneft abandoned its $2bn-$3bn five and 10 year Reg S/144A bond. Eight bookrunners were mandated on the bond, part of the capital markets portion of the $24.5bn loan Rosneft took out to finance its acquisition of the remaining vestiges of Yukos. ABN Amro, Barclays Capital, Citigroup and Morgan Stanley were the designated active players, with responsibility for pricing and allocations. Yet despite a successful roadshow, the borrower opted to abandon the deal. Peter OBrien, the oil companys vice president and head of finance and investments, said Rosneft wanted to raise the funds "but not at any cost". The Baa2/BB+/BBB- rated oil company believed its scarcity value and 75% ownership by the government justified pricing flat to or through the higher rated Gazprom (A3/BBB/BBB-). Gazproms five year CDS were trading at around 67bp.
There were umours that the company was fixated with pricing flat to Gazprom, although OBrien denies this. The company has until September 2008 to raise the remaining $11bn it has not already refinanced of the $22bn bridge loan. Rosneft may tap the Eurobond, rouble bond, Russian bank, syndicated loan, convertible bond, project finance and equity markets to raise the funds. "The Russian bank market is increasingly deep," says OBrien. "State banks have IPO-ed and improved their capacity to lend to large credits like Rosneft."
But bankers are unanimous: to get deals away, Russian borrowers, like their western European counterparts, will have to accept the new pricing paradigm.
"Most issuers have experienced ever-improving pricing over the last few years," says Gareth Thomas, global head of emerging markets at ABN Amro in London. "We have a new reality now pricing levels have permanently re-set and we dont expect spreads to return to June levels during this cycle."
Despite this, one message bankers seem keen to convey to borrowers is that despite the blow-out in spreads, and rising new issue premiums, the US Treasury rally since July has meant that in absolute yield terms, issuers can still borrow at competitive levels.
Cracks start to show at the banks
As in 2006, most new issues in Russia this year have been from banks. But despite being far less reliant on international funding than their Kazakh counterparts, Russian bank spreads have widened sharply.
In August, as international investors fled the Russian money markets, the Bank of Russia posted a private capital outflow of $9.6bn in the third quarter of 2007, compared with a $52.7bn inflow in the previous quarter. A host of borrowers have postponed deals and are instead relying on repo finance to support their operations the Bank of Russia has been pumping about $2.5bn into the system every day via one-day repo auctions since the last week in September, when monthly tax payments became due. To ease the situation, in October, the Bank of Russia lowered minimum reserve requirements for banks and announced it was accepting banks credits as collateral for loans. The first such loan was extended to VTB, which received Rb6.9bn at 7.5%. The Bank of Russia then took VTBs credits to Rosneft as collateral.
Yet, many in the markets believe that despite concerns over liquidity, the sell-off in the Russian bond market is overdone.
"Most Russian banks pursue a very different funding model to banks like Northern Rock, often with long term funding and shorter term assets," says Thomas at ABN Amro. "We think concerns in the Russian banking sector are overdone we dont see casualties in Russia, but naturally investors remain concerned about the fixed income sector generally."
In October, tough new regulations and the global liquidity squeeze took their toll on Russian Standard Bank, the countrys largest privately owned consumer lender, with Fitch downgrading it to BB- from BB and Moodys lowering its outlook from positive to stable.
Small banks face uncertain future
Aided by an increasingly affluent middle class, the banks have enjoyed lower credit loss charges, better profitability and growing diversification of their business. But despite improvements, there persists a weak legal and regulatory framework and a lack of transparency in the system. "Progress on bank reform is still hesitant, due to a lack of political willingness to tackle major weaknesses and opposition from parties with vested interests," says Ekaterina Trofimova, an analyst at Standard & Poors in Paris.
The banking system remains vulnerable to panic-driven periods of illiquidity and dramatic rises in interbank lending rates then again, which countries' banking systems can say they are isolated from such events? Says Paul Biszko, an analyst at RBC Capital Markets in Toronto: "There has been significant pressure on local rates. We believe there is a high risk that a number of smaller tier two banks may fold as a result of this crisis. Many have gone to foreign banks asking for money but have been cut-off".
"One consequence of this is that we've seen tighter credit standards and a hoarding of liquidity by the Russian lenders," he adds. "We definitely see consolidation in Russian banking reform in the banking sector has been very slow and the authorities have seemed keen over the last few years to reduce the number of local banks, currently numbering in excess of one 1,000." Indeed, VTB is in talks with three consumer lenders on buying up their portfolios.
In the short term, foreign debt refinancing needs among the Russian banks appear manageable but the drain in liquidity could constrain banks growth and potentially expose the weighting of bad loans in their portfolios. International syndicated and Eurobond borrowings, which represent the core part of Russian banks international indebtedness and are most subject to refinancing and repayment risk, are below $5bn for the remainder of 2007 and below $20bn for 2008.
And if liquidity in the syndicated loan market remains thin on the ground, banks may be forced to re-enter the bond markets, providing opportunities for foreign banks. "Although the bond market is now more expensive, we are also seeing a tightening up of the syndicated loan market, particularly for financial institutions," says ABN Amros Thomas.
And, according to some, this may provide opportunities for foreign lenders foreign lenders can now offer funding at more competitive rates than Russian borrowers can get in the local markets. Extending facilities now can enable foreign banks to shore up relationships with borrowers and gain a virtual stranglehold on future bond mandates.
"Relationships are the key to successful syndicated loan deals right now and a lack of capacity in this market should keep Russian bond issuance at reasonable levels," says Thomas.