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Caution for corporates as Eurobond market remains off limits

14 May 2009

Forget new issues: buy-backs, restructurings and staving off default remain the priorities for Russian Eurobond issuers in 2009, writes Francesca Young. Only Gazprom has a different story to tell.

Foreign debt markets slammed shut to Russian corporate borrowers last year, leaving a sector that had grown accustomed to easy dollar financing terms scrabbling for alternatives. So when Gazprom, the state-owned oil and gas company, reopened the market in April, there were hopes that others could follow. State support for issuers, though, remains the bulwark for the market — against both illiquidity and insolvency.

Gazprom has been the sole Russian issuer of Eurobonds since last summer, selling a dollar benchmark in April after earlier printing an opportunistic Swiss franc note. But rather than opening the door for other borrowers from the CIS, Gazprom instead proved that in many ways it stands alone.

To sell the dollar deal, Gazprom located a deep pool of private bank demand to print $2.25bn of new 10 year bonds, puttable after three years. That dollar deal is now trading around 98.25-98.75.

The Sfr500m two year deal, which pays a coupon of 9% and was priced at 822bp over mid-swaps, performed strongly when it was priced in the first week of April. That private deal is now illiquid.

Emerging market syndicate officials said at the time that international institutional investors would not be interested in a Gazprom dollar deal at price talk — 9.25%-9.5%, inside Gazprom’s secondary curve at the time, except its 2009 maturities.

But the impetus for the dollar deal helped the sale work. It refinances a ¥175.9bn ($1.78bn) bilateral loan to Gazprom from sole bookrunner Credit Suisse maturing in 2018 and puttable in 2011. So, the bond enabled the Baa3/BBB/BBB rated company to replace a yen liability with a longer duration dollar issue while giving Credit Suisse a more liquid asset with better returns. Credit Suisse was therefore content to take a portion of the bonds, while private bank investors were also impressed by the price for a three year deal.

"The new Gazprom [dollar] deal has underperformed since issuance, but that’s unsurprising given that the issue size was at the wide end of expectations," says Paul Timmons, a London-based emerging markets trader at Commerzbank. "At $2.25bn, the bond is the largest issue across the Gazprom curve and in contrast to previous placings, full allocation would have been the order of the day and in turn, exacerbated the initial selling pressures."

But others were unconcerned that the bond was trading below par and the deal prompted a rally across the curve and priced at the tight end of guidance.

The illiquidity across EM secondary curves was a key driver of the attractiveness of Gazprom bonds. In recent months it has been difficult to obtain large sizes of single names in the secondary market and this new deal enabled accounts to buy chunky bonds in a single name and issue.

But this deal is unlikely to open the gates to a flood of quasi-sovereign issuance from Russia, said syndicate bankers.

"The situation with Gazprom and the involvement of Credit Suisse was very specific," says a London-based emerging markets syndicate banker. "Gazprom and a handful of other Russian quasi-sovereign issuers have always been able to place a deal if they wanted to, it’s just a case of whether the price is attractive to them and at the moment the prices indicated by the secondary market still don’t look good."

State support

Some traders are particularly sceptical about the prospect of new issuance from Russia compared to other emerging market countries.

"The CIS market still retains a degree of fragility given the underlying credit metrics and the performance of the Gazprom issue will make investors cautious of future benchmark issues from Russia," says Timmons. "By contrast, recent Asian sovereign and banking issues have performed extremely well."

Instead of using the Eurobond market, Russian borrowers are instead relying on bilateral loans from the big local banks, Sberbank, VTB and Gazprombank, which have been given state funding amounting to Rb1.13tr in order to extend loans to other reliable borrowers finding it difficult to access international markets.

With the capital markets closed to Russian corporate issuers or secondary yields making it punitive to issue new deals, companies including TMK, Mechel, Lukoil and Vimpelcom have already received funding of this sort this year.

The Russian state development bank, Vnesheconombank (VEB), has also been a key policy tool for refinancing the foreign debts of Russian corporate borrowers.

Buy, don’t sell

Other issuers are taking advantage of the high secondary yields in the Russian Eurobond market. Some have been buying back bonds trading at low prices. But investors, syndicate bankers and traders are divided as to whether this is sensible or whether a good deal now may be regretted in the future.

"Buybacks are awesome," says US-based Ray Zucaro, portfolio manager at Drake Capital Management. "It’s great for the investors as it’s a chance to get out if they want to, kind of like having a put option they haven’t paid for. And if you’re a buy and hold investor who intends to keep the bond to maturity, then a company buying back their bonds is good because it makes the overall debt of the company less onerous."

Russian bank borrowers have been particularly busy buying back their own debt, taking advantage of the liquidity provided by the Bank of Russia’s (CBR’s) repo facilities, and, for some, of higher deposits. Some traders are concerned that these buybacks are reducing bond market liquidity.

"The buybacks are done at generous yields, which is a positive for the issuer, but the exercise has removed a large degree of liquidity from the market," says Timmons.

Another syndicate manager agreed, adding that in particular problems are being caused by the buying bank of bonds on the secondary market, rather than by issuing an exchange offer.

Stock exchange announcements should be made by the issuer once enough bonds have been repurchased on the secondary market such that liquidity is hampered, but there is no strict rule for what percentage of the bonds this constitutes, and so can vary from issue to issue.

"From a liquidity point of view [buybacks are] bad, but I think overall if you’re able to hold it, you’re probably better off as an investor for the company having performed the buyback anyway," says Zucaro. "From the company or bank’s perspective, if you owe a hundred dollars and you’re able to take it out at 60, then it’s pretty hard to find a better return on investment in any business."

Others are also more concerned about the potential long-term funding needs of the issuers buying back bonds.

"The buybacks seem like a good idea now, but if this credit crunch lasts longer, are the issuers who have bought back bonds going to wish they hadn’t spent the money on that? It’s too early to tell," says the EM syndicate manager.

Ursa Bank, VTB and Gazprombank have all made tender offers to repurchase substantial portions of their own bonds this year.

The buybacks could have previously been seen as a way for issuers who were overexposed to the US dollar to manage that exposure. But although the devaluation of the rouble was high on the list of concerns for investors and issuers as the rouble fell more than 30% against the dollar earlier this year and debt ratios rocketed, those concerns have somewhat receded.

"There isn’t as much concern over further devaluation of the rouble — and as long as crude oil stays north of $40 a barrel, as the CBR has openly declared, then intervention will be limited," says Timmons. "Coupled with improving prospects for capital inflows, that’s the best indicator you can take for sustainability of the rouble at current levels."

Staving off default

Russian Eurobond defaults have so far been few and far between, despite the difficult environment for rolling over debt and the devalued rouble.

Siberian Services Co., an oil-drilling company, was the first Russian borrower to default on its foreign debt in 2009, failing to redeem its $100m 13.75% notes on 3 April after bond holders exercised a put option. Creditors have formed a committee to push for full repayment of the debt, which could force the company into bankruptcy.

Baby-food producer Nutrinvest holding defaulted on $50m bonds in December and RTM Development did not pay out for the put option exercised on its $55 million of bonds in November.

But far more worrying is the default of Finance Leasing Co., a state-owned Russian aircraft leasing company which defaulted in December. FLC may be liable to repay $250m, having failed to make coupon payments of $12m on its $150m 10% 2013s and $100m of 9.25% 2011s.

The Moscow-based airplane leasing company is owned 28.7% by the government and 51.8% by United Aircraft Corp, the state-controlled aerospace group. No other government-supported company has failed to service its foreign currency debt since Russia defaulted on its sovereign bonds in 1998.

However although letters of comfort were signed by UAC’s chairman, Alexei Fedorov, explicit support was not given, leaving it debatable as to whether UAC and the Russian government are liable for the repayment.

Emerging market participants agreed that second and third tier issuer defaults were expected, but default risk is largely ignored for Russian state-owned companies and banks.

"There have been third tier and second tier rouble defaults and one or two in the dollar space for third tier credits, but the market seems to have absorbed all this news and simply shrugged it off," says Timmons. "As long as trouble is avoided with the top names, risk appetite will continue to improve."

And other investors are confident that the government will take steps to support the banks.

"A previous banking crisis is what swept Putin into power, so I don’t think the banks are going to be allowed to default because from a social unrest point of view it’s politically unpalatable," says Zucaro. "I think there will be implicit or explicit government support in rolling over the banks’ obligations, whether they change tier two requirements for capital, or they change how to calculate capital — the Russian authorities might be creative, but they won’t let the banks blow up."

But a wave of put options will fall due this year, particularly in the Russian domestic market, and failure to meet those put options could trigger cross defaults on Eurobonds for some of those borrowers.

For the moment, the CIS remains the pariah of emerging market bonds, and Russia is still regarded with caution.

14 May 2009