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Rouble market fizzes as Russia advances

20 Oct 2005

Russia's bond market has recorded a stellar performance so far this year and the rich run of issuance shows no sign of slowing up. With a new wave of deals expected in the final quarter, Duncan Kerr reports on a market buoyed by the stream of oil money and international interest drawn in by yield and an ever increasing range of borrowers.

Ask any Moscow-based bond trader about how well the rouble market has performed in the first nine months of the year and they will more than likely reply in superlatives.

By the end of September just shy of $5bn (R140bn) had been raised in the domestic bond market from over 80 issues, compared to $3.25bn from 68 in the same period the year before.

Although first quarter issuance of $912m was down by around $375m compared to the first three months in 2004, the next quarter more than made up for that with 45 bonds issued for around $2.3bn equivalent.

In the second half of September the market returned after a summer lull and deals were fired off in quick succession in one of the busiest couple of weeks bond traders in Moscow have experienced for some time.

"The market is hot and conditions for new deals to come to market are extremely good," says Andrey Dobrynin, director of international capital markets at MDM Bank in Moscow. "September turned out to be a tremendous month and business does not look like it will fall. With our pipeline of deals for the final quarter of the year full, we are expecting the rouble bond market to be very busy through October and into November."

September was a record month for new issuance with private banks and corporate borrowers bringing transactions that met with roaring demand from local and foreign investors.

Attracting a book of R9.1bn from over 66 accounts, Russian Standard Bank's R5bn five year was typical of this pent-up investor demand for fresh rouble credit. It was the biggest bond to have been placed in Russia by a privately owned bank.

Joint leads Gazprombank and ING Bank priced the fifth domestic bond from Russia's consumer finance leader at par with a coupon of 7.6%. This was wider than the tight end of the price range of 7.12% to 8.7% but cheaper than the 8.25% coupon forked out by Russian Standard Bank's consumer finance rival Home Credit & Finance Bank on its R3bn five year with an 18 month put option through Raiffeisenbank Moscow and Vneshtorgbank.

The two deals, however, were targeted at different investors — 97% of Standard Bank's deal was sold to international accounts while 60% of Home Credit's bond was taken down by local buyers.

In the same week, fixed line telephone company Sibirtelecom raised five year funds through Svyazbank and Promsvyazbank by launching its punchy R2bn five year put three transaction with a coupon of 7.85%, while RusalFinance — the holding group of the aluminium production company — went for a three year maturity with its bumper R6bn bond through Rosbank, Soyuz Bank and Gazprombank.

That pair of deals eased the way for Irkut, the aircraft equipment manufacturer, to push out its R3.25bn five year deal through MDM Bank, Vneshtorgbank and Sberbank before Ochakovo Brewery issued its R1.5bn three year via bookrunner Raiffeisenbank Moscow and joint lead Predolenie Bank.

"The volume of bond issuance from all sectors so far this year has been huge," says Pavel Gourine, head of corporate and investment banking at Raiffeisenbank Moscow. "And in the three remaining months of the year there could be up to $5bn of deals to come — which is of course close to what has been issued in the first nine months."

Deal jam

Boris Ginzburg, head of fixed income research at Moscow-based Bank UralSib, is just as bullish about the tally of deals to come in the final quarter of the year — which Ginzburg says could total R150bn-R200bn ($5.25bn-$7bn).

For Michael Workman, head of credit research at Trust Investment Bank in Moscow, the reasons for this deluge of deals are clear.

"We are seeing a lot of interest in the rouble bond market from both Russian and international banks, which is primarily driven by the real appreciation of the local currency versus the dollar and excess rouble liquidity in the banking system," he says.

"Those drivers are a result of Russia's impressive current account surplus and the central bank's exchange rate policy. In the current environment we believe this liquidity can absorb all of the new issuance."

The depth of demand will be tested this quarter if the deals being talked about are realised. However, the market's capacity could be proved once and for all by just one deal — the long expected R35bn four tranche bond from Russian Railways, which is set to hit the market over the next two months.

The transaction, the biggest ever issued in the domestic market, will comprise a R10bn 1.5 year tranche; a R10bn three year, R10bn five year and R5bn seven year. KIT Finance, formerly Webinvestbank, and JP Morgan have been mandated to lead the deal for the Baa3/BBB- rated state owned company which runs the country's sprawling rail network. 

But though Russian Railways may be poised to take the crown for raising the biggest chunk of rouble capital in the bond markets, the City of Moscow, rated Baa3/BBB/BBB, sets the benchmark for price and liquidity.

"We are sitting tight and buying back some of our domestic debt using extra revenue from the city budget," says Sergy Pakhomov, head of funding at the City of Moscow. "That's the plan for the rest of the year before we return to the local and international bond markets in January next year with an aggressive borrowing plan." The city will borrow R72bn in 2006 — R56bn in new deals and the rest refinancing.

The plan is to issue in the 10, 11 and 15 year parts of the curve, which would give it the opportunity to create a basket of bonds and "thereby establish an interest rate futures market for Moscow's longer term debt," adds Pakhomov. The interest rate futures market for Moscow's three year basket of bonds started on the RTS (Russian Trading System) exchange in May this year.

Moscow's prudence — and indeed, abstinence from issuing new paper since its R12bn five year in April and R5bn three year in September — has benefited the borrower. Yields on its bonds have tightened over recent months by roughly 50bp-60bp. "Our bonds are now trading at about 6.75%-6.85%," says Pakhomov. "One month ago the yield was slightly over 7% and two months ago it was around 7.25%."

Alpine yields

Foreign investors' participation in the rouble bond market, whether direct through hedge funds or indirect through the Moscow-based subsidiaries of Western investment banks, has been increasing in each of the last three years. Their greatest participation is in the City of Moscow's bonds.

"In the short part of the curve they own up to 90% of the debt," Ginzburg at UralSib says. "At the long end, they hold around 40%."

However, there are still few foreign investors in the OFZ (local government debt) market  because of domestic legislation. Non-residents also buy few corporate bonds, and mostly liquid issues from big names such as Gazprom or Lukoil.

"We see interest from the more aggressive type of investors like hedge funds, which understand that there is not much upside left in the first tier names and want to move into higher risk/return assets, or what is called in Russia second and third tier bonds," says Workman at Trust.

"However, a lack of sufficient liquidity in such issues from our view is an important obstacle for international investors. Even in the most liquid second tier names one cannot buy or sell $5m worth of bonds without significantly moving the market."  This is often the minimum size at which foreign operators can operate efficiently. "This obstacle will certainly not disappear this year," Workman continues. "It will take the rouble bond market two to three years to deepen sufficiently."

The few foreign accounts to have invested in the market so far have had a disproportionately large impact on the market's composition, because of their willingness only to invest in names such as Gazprom. For instance, yields on the first tier range from 7% to 9% and those on the second tier from 12% to 15% and even higher. There is a third tier of speculative credits that trade anywhere above 15%.

However, local investors are migrating to higher yield, lower credit quality bonds.

"This implies higher vulnerability of the local financial institutions to credit shocks," says Workman. "Russian investors are primarily banks, which have a relatively high cost of funding. After the yields have gone all the way down following all the good news around Russia, local investors have become less active in Eurobonds and first tier rouble bonds and have migrated to the second and third tier rouble bonds, while international investors have increased their presence in the first tier."

Russian investors' fear of double digit inflation is one reason why they cannot afford to hold on to rouble denominated paper until maturity. However, provided the currency holds up, foreign investors need not worry whether bond returns will be higher than Russian inflation, which the Central Bank of Russia is aiming to hold at 8.5%. 

"Foreign investors are betting on the rouble via the domestic bond market," says a Moscow-based banker. "For example, OFZs offer spreads in the region of 100bp-250bp, and if investors then expect another 1%-2% of rouble appreciation it is attractive."

But there are concerns about what effect a turnaround in the rouble/dollar rate — which has long moved in favour of the rouble — would have on the market's future.

Workman cautions: "If the rouble were to start nominal depreciation versus the dollar, whether due to a fall in commodity prices or US dollar gains versus major currencies, we might quickly face a dry-up in rouble liquidity and capital flight, resulting in a distress in the rouble bond market, similar to the one in spring to summer 2004." 

EBRD brings floaters to Russia

 The European Bank for Reconstruction and Development (EBRD) became the first international issuer to sell rouble denominated paper, launching a R5bn (Eu140m) five year floating rate note in May.

The EBRD had been considering a rouble denominated issue for some time, partly because it increasingly needs local currency financing for its projects in Russia, and partly because its mandate is to stimulate the growth of local capital markets in the countries in which it works.

Russia is the largest recipient of EBRD funding — since 1991 it has committed Eu5.87bn to the country in 212 projects. 

With no provision in the legal infrastructure for international borrowers to issue in Russia, the EBRD worked with the regulatory authorities before a new securities law was passed in December 2003, which for the first time recognised international issuers.

However, the agency still had to work with the Federal Financial Markets Service and Micex to create rules and regulations for an issuing regime. The bond is Russia's first floating rate deal.

Isabelle Laurent, deputy treasurer and head of funding at the EBRD in London, said the structure was likely to grow in popularity and that the purpose of the floating rate note was to introduce a new asset class in Russia and stimulate the development of a functioning money market.

Among other innovations, the deal led to the creation of the Moscow Prime Offered Rate, a new money market index designed to serve as a transparent benchmark for top-rated financial institutions wanting to raise funding in roubles. Eight banks contribute quotes to the MosPrime Rate.

The bond's calculation agent will determine the coupon for the EBRD's issue on a quarterly basis — the first three month rate was set at 4.04%. Resetting every three months, the deal's coupon has since accreted and is now set at 4.67% until November 2005.

Citigroup and Raiffeisenbank Austria lead managed the deal, which had a syndicate of 10 Russian and international banks. 

20 Oct 2005