After much hype - and volumes in excess of R100bn - Russia's growing corporate bond market has lost its momentum. But is this a temporary glitch or a more serious set-back to the market's development? Kathryn Wells assesses prospects for the remainder of the year.
This year is proving to be a game of two halves for Russia's burgeoning domestic bond market. After the runaway success of the first half of the year, which saw the level of corporate paper in circulation reach R100bn ($3.3bn) and yields fall below the rate of inflation, the market correction that has followed looks set to ensure that further growth remains hampered until the end of the year at the earliest.
Gazprom, which announced in September that it was postponing a R10bn issue because of poor market conditions, has proven a bell-wether for the market. Its outstanding bonds, which were trading at yields as low as 9.8% in late May and early June, then widened out as far as 14%-15% over the summer, before returning to more rational levels of 11.4%-11.5% by September.
Second and third tier issuers have suffered even more at the hands of volatile markets, experiencing yields as high as 17% over the summer months.
Several issues at the end of May marked the turning point of the market. Oil pipeline company Transnefteprodukt priced a R1bn three year bond with an 8.9% annual coupon via Troika Dialog, telecoms firm Vimpelcom Finance brought a R3bn three year bond with a one year put option with a coupon of 8.8% via Raiffeisen Bank, and aluminium producer RusAl Finance issued a R5bn four year deal including a 24 month put option with a 9.6% semi-annual coupon via Trust Bank and MDM.
Following these deals, yields shot up and the new issue pipeline became blocked. Many see this exaggerated correction as inevitable, given the speed with which the market developed from the end of 2002 until yields widened in May and June. "When corporates were placing bonds at yields of 8%-9%, but infaltion was around 14%-15%, the market was clearly unsustainable," says Andrey Dobrynin, director of international debt capital markets at MDM Bank in Moscow.
Too much too soon
A combination of causes was behind the steep fall in yields. "The main cause of the rally this spring was a rally in government bonds," Vadim Solomakhin, head of the investment department at Bank Zenit in Moscow. "The ministry of finance issued some longer dated five, 10 and 15 year rouble bonds, which pushed yields down."
"Once investors saw that yields were coming down, the corporate bond market looked like a good play," he adds. "There was an influx of money from small and medium sized banks, speculators from the equity markets and big foreign names. After the government rally, investors turned their attention to the municipal issuers and the first tier blue chip corporates. Yields came down across all tiers, and this continued until the end of May."
In addition, external forces played a role. "There were two reasons behind the events of the summer," says Pavel Mamai, chief debt strategist at Renaissance Capital in Moscow. "Firstly, by late May, the market had pushed yields to unjustified levels and every company that came to the market saw yields continuing to go down.
"Secondly, turmoil on the US government debt markets put pressure on Russian external and domestic debt."
The increased volatility that this led to did not only affect the Russian domestic market. "In the run-up to the summer, the global environment was very positive for emerging market bonds, as Treasuries were down to record levels so the funds carried over to the emerging markets," says Michael Workman, director of fixed income research at Trust Bank in Moscow. "But in the summer the Treasury position reversed, and overall risk appetite lessened."
Pavel Gourine, head of investment banking and member of the board at Raiffeisen Bank in Moscow, points out several other causes. "There was an excessive supply of roubles in the market, resulting from high oil prices," he says. "We also saw a growth in Eurobond market prices, which created an excellent opportunity for the rouble bond market.
"In addition, the rouble appreciated against the dollar, freeing up some cash that had been invested there."
Bureaucratic regulations that delay bonds being traded on the secondary market for up to four weeks after they are priced also had an impact. "With high demand for primary placements, speculators came into the market," says Gourine. "In an environment of falling interest rates, those who bought on the primary market made a huge profit over the one month gap between bonds being priced and then being freed to trade, as yields were falling."
The short term nature of the majority of the market's investors led to speculation on falling yields. "Banks provide 80% of liquidity in the Russian investor base, and they have short term liabilities," says Dobrynin at MDM. "By buying longer term bonds, they create mismatches, so they need to be able to sell the bonds on to get liquidity. On average, banks had higher funding rates than corporate bond yields, so they have to bet on making gains through trading the paper."
Corporates looking to issue paper became more aggressive as they saw yields trending downwards. Most issuers already demanded firm underwriting commitments from their banks well in advance of the bonds being priced.
When the market began to turn, these banks were forced to sell off their existing portfolios to make space for the new deals that they were unable to sell.
"Many of the issues placed before June went on to underwriters' books, so they had to free up their positions to absorb these new issues, which led to a phase of selling off," says one banker in Moscow.
More supply than demand
One effect of the market slowdown has been to create fears of oversupply in the second half of the year. Because of the long registration process, many issues that were registered in April or May did not have time to make it to market before yields shot up. "There is about a R50bn overhang at the moment, leading to fears of oversupply as liquidity disappeared," says Alexander Popov, chairman of the board at Rosbank in Moscow. "Some issues have since been postponed or have disappeared from radar screens."
The market is not expected to make a complete turnaround within a matter of weeks or even months.
Oil pipeline company Transneft's plans for a debut R12bn three year bond are still understood to be in place, but other top corporates such as Gazprom have already decided to postpone their issues. One of the first was mobile phone operator MTS, which in July decided to postpone a R5bn three year issue, opting instead for a $300m one year FRN via Credit Suisse First Boston.
Analysts said at the time that the decision to issue Eurobonds rather than rouble bonds was motivated by rising rates in the domestic market. The new Eurobond had a yield to maturity of around 6.15%, or 8.15% in rouble terms, one analyst said, whereas domestic bonds could only have been placed at around 9.5%-10%. The FRN has two call options, after six and nine months - both at par.
As a result, the developing trend towards fewer bonds including put options has been reversed, at least for those deals that are being brought at the moment. "Most companies looking to issue are now including put options, as investors are more comfortable with the shorter part of the maturity curve," says Gourine at Raiffeisen.
Bankers close to the Transneft deal, which at R12bn will be the largest corporate issue when it is launched, suggest that an 18 month put option may well be included in an effort to entice investors, who now prefer the shorter part of the curve, into the deal.
Transneft has appointed a group of five investment banks, the largest number of lead managers seen so far on a corporate domestic bond, to arrange the issue. But while before the summer meltdown, the oil and gas pipeline company could have expected to price its bond with a coupon below 10%, it will now have to pay a double digit coupon to get the deal done.
Bankers believe that levels are about right to begin buying cautiously again, but the market still lacks liquidity. "The market needs liquidity to pick up," says Solomakhin at Zenit.
"We expect rouble liquidity to be better at the beginning of next year, when market participants will begin to form portfolios for the new financial period."
Much will depend on the direction of the rouble/dollar exchange rate. The rouble has been appreciating so far this year, mainly as a result of high oil prices. "We hope that the dynamics of the rouble/dollar exchange rate will happen in stages during the remainder of this year," says Solomakhin at Zenit. "When we reach a new rouble/dollar level, some market participants will go short on dollars and will place roubles from these operations into the rouble denominated market."
Approaching parliamentary and presidential elections also carry a risk of volatility. "The forthcoming elections are not really a risk in their own right, but are certainly a factor that issuers and investors will consider going forward," explains one Moscow-based banker.
On the positive side, the market is waiting for an expected sovereign upgrade from Moody's, which should then have a positive knock-on effect on to a range of sub-sovereign and blue chip names.
The summer's correction has had some positive influences on the market. Until recently, investors were only concerned with the coupon that they could achieve on a bond, and did little if any credit evaluation.
Similarly, some companies did not feel the need to give investors the transparency and levels of information that they would be obliged to on the international markets.
"Investors are now paying more attention to credit risk," says Solomakhin at Zenit. "Some companies that entered the market at the beginning of the year, which did not have international accounting standards and lacked transparency, suffered the most in the market correction.
"Companies now realise that if they want to attract yields at the levels of the first tier, they need IAS. Otherwise they will be looking at levels of 17%-19%."
While investors are becoming more willing to do their credit homework, there is still a long way to go. "The last few months have taught people about credit differentiation," says Workman at Trust Bank. "But at the same time, credit analysis is an art rather than a science in Russia. We prefer to look at relative value within sectors."
Russia's first tier consists of blue chip names such as Gazprom and selective municipal names such as the City of Moscow, while telecoms and regional energy firms dominate the second tier. "In Russia, the second tier issuers do not have name recognition, so are priced at a premium to the first tier," Workman adds. "Many of the smaller bonds of the third tier are more like syndicated loans than bonds, and have very little turnover."
But, surprisingly, these less well known third tier issuers have not been closed out of the market entirely during the recent volatility. "Deals are still happening for the third tier, but not genuine market deals - $5m-$25m in size," explains Workman. "They are being purchased by banks and put on their books until the market improves and they might be able to sell them."
Other bankers agree that these corporates can achieve financing in tough market conditions. "There is a niche for third tier issuers," says one. "Some of the most recent bonds might be classed as such, which have quarterly coupons and high premiums." Most recently, issues such as a R400m three year bond from Yakutskenergo with an 18% coupon, and a R600m two year bond from Altayenergo with a 17.5% coupon, could be classed in this group.
It will be in the first quarter of next year, one year on from when many of the third tier bonds began to be issued, that the threat of default will become more pressing.
"The risk of default has gone up, but it probably will not happen until many of the junk bonds mature until early next year," says Dobrynin at MDM. "But if the market does not rally significantly, then the third tier will find it difficult to refinance these deals. These corporates will not have a sufficient cashflow to sustain repayment."
Bankers generally see a third tier default as holding little threat to the market's development. Indeed, it might have a positive impact of making investors more careful in their credit analysis. And, while default by a first or second tier company could have a more serious impact on the market, bankers agree that there is little prospect of this occurring soon.
The coming months will be crucial for the market's development and will help to determine whether it can grow in importance as a genuine funding instrument for Russia's largest corporates.
Bankers would also like to see a change in legislation to reduce the cost of issuing. Borrowers must at present pay a tax of 0.8% on each issue - one of the main reasons behind the development of longer dated issues carrying put options - which acts as a disincentive to many corporates considering launching a deal.
"The high registration cost is a big issue that affects potential issuers," says Mamai. "The correction has also highlighted the lengthy and bureaucratic process of issuing. It takes up to three months to issue a domestic bond, and companies that had made the decision to issue back in April or May when the market was rallying have since been unable to issue. The market needs flexibility, not a huge placement risk."
Many suggest a level of around 0.2% as more appropriate, although few bankers believe that the subject is being given much priority by decision makers at the Federal Securities Commission. "It is a huge problem for big issues for good names - and for underwriters - to commit themselves to certain levels weeks before the deal is brought," says one banker.
Much has been made of the impact that the introduction of pension fund money will have on the domestic bond market from 2004. But most bankers and analysts err on the side of caution. "Initially, pension funds will represent a trickle rather than a wall of money," says Workman at Trust Bank. "The money will be concentrated in a handful of corporates in the first tier, and we will see a true Russian investment grade versus high yield materialise."
Earlier this autumn, the government drew up a list of 55 investment companies that have been authorised to act as pension funds. But in reality, the amount of money that they will receive in the early days of the new scheme is likely to be small.
"With the advent of pension funds in 2004, we expect that up to 95% of consumers will stay with the state pension fund run by Vnesheconombank," says Popov at Rosbank. "In line with its previously stated commitments, Vnesheconombank will invest around 80% of its funds in the government bond market, leaving little to trickle down to corporate issues. This means that while pension funds will have an impact on the corporate bond markets, this is likely to be minimal in the early days."
As a result, few are optimistic that the pension funds' impact will be felt from January 1 2004, and intensive lobbying is still under way over the exact regulations that will govern their activity. "The pension funds will have a huge impact if the implementation of pension reform is carried out properly, but there is no guarantee that the necessary steps will be completed in time and 2005 looks like a more realistic timeframe to see their money having an impact on the market," says Alexei Sizov, managing director of debt products at Renaissance Capital in Moscow.
But all agree that their future influence is likely to be widely felt, spurring the market on to new levels of development.
"The pension funds will have a very positive effect, and will mark the beginning of the second stage of the market's development," says Dobrynin at MDM. "The first stage was the creation of the instruments themselves, while the second will be the creation of supply of long term money."
Concerns have been expressed that the influx of pension fund money could have a similar effect to that experienced in Kazakhstan, where a flash flood of pension fund money exceeded the limited supply, pushing yields down to unnaturally low levels.
This is not thought to be an imminent threat to the development of the market in Russia, given the relative size of its economy compared with its neighbours.
"The Russian economy is much bigger and more diversified than the Kazakhstani one so there should be little threat of Kazakhstan syndrome," Dobrynin continues. "At some point the domestic market should overtake the external markets in significance for Russian corporates looking to raise funds."
The advent of pension fund money will help to lessen the influence of short term banking sector money on corporates looking to issue. "Banks still make up around 70% of the investor base, but the influence of non-banking institutions is higher on a deal's final conditions, such as maturity, as banks are more speculative," says Gourine at Raiffeisen.
When the going gets tough...
As a result of the boom during the first half of the year, several newer, smaller or regional Russian banks became more active players on the rouble bond market, seeing that there were tidy profits to be made. Many of these have been the hardest hit by the correction, with a number choosing to exit the business.
Today, a group of around 20 banks underwrite the majority of bonds, but only between six to 10 have the capacity to lead manage new issues. "In the boom market, banks did not need to have good distribution capabilities, as investors were keen to buy paper," says Dobrynin.
"It was just a case of winning the mandate, and almost all banks offered firm underwriting commitments. Today, banks do not offer the underwriting commitment and are acting more like normal distribution houses."
Austria's Raiffeisen is to date the only international player to have made significant inroads on the domestic market, and there are only limited signs so far that other foreign players will look to take a major role. "It will be interesting to see what foreign banks' appetites are like for bring rouble bonds - it is likely to depend on whether they have strong client relationships," says Workman at Trust.
Citibank arranged a R1bn three year bond for Russian Standard Bank in June, but the trend so far has been limited and is likely to remain so until the market picks up, possibly not before early 2004.