When describing Russia's political scene, stability is an understatement, and bond investors are quite happy with that. Economically, Russia is going from strength to strength, and full investment grade status is only a matter of time. With yields evaporating on European corporate bonds, more and more investors are eager to buy exposure to an ever wider range of Russian issuers. Philip Moore reports.
It could only happen in Russia. The entire cabinet is peremptorily fired by an increasingly autocratic President and the bond market barely flinches.
True, the Russian stock market and the rouble both sold off modestly after President Putin's early spring-clean in February.
But after an initial, knee-jerk fall, the Russian Federation's benchmark 30 year Eurobond recovered almost all its losses on the first day. Investors were apparently much more interested in the influence on the bond of the performance of the US Treasury market, than in the comings and goings in the Kremlin.
Debt capital market participants who paused to think through the implications of Putin's surprise move saw little to perturb them, and some even viewed it as a development with attractive facets for holders of Russian Eurobonds.
"If President Putin is becoming more autocratic that's not necessarily a bad thing for investors," says one head of emerging market bond syndicate. "It means people can be sure of who is in charge in Russia rather than constantly having to reassess the political landscape. The dismissal of the cabinet should be seen as part of the political process in Russia, not as a cause for concern among investors about whether they will be paid their principal and interest."
Other bankers clearly agree, and will not be allowing a political storm in a teacup to alter their bullish outlook on the Russian Eurobond market for 2004.
"Last year there was about $8bn of Eurobond issuance from Russia, which was a record year, and we have no reason to believe volumes will drop this year," says Petri Kivinen, head of EEMEA origination at Dresdner Kleinwort Wasserstein (DrKW) in London. "The new issuance pipeline is already building up and if anything it is likely that volumes will increase in 2004."
A bumper year expected
It is easy enough to grasp why, even after a slow start in January and February, syndicate chiefs are confident of a bumper year in Russia, with new issuance volumes expected to rise rapidly, now that the Presidential election has passed off as predictably as everyone expected, with a landslide victory for Putin.
With the election out of the way, market participants expect that investors will be able to re-focus on fundamentals, and that they will like what they see.
Most obviously, institutions will appreciate the strength of the economy and its implications for the sovereign rating, which is already widely viewed as being investment grade-in-waiting across the agency board.
For the time being, Russia is three-quarters of the way there. Moody's did half the job last October, when its surprise (and, to many, premature) double upgrade from Ba2 to Baa3 catapulted Russia into investment grade territory.
S&P has moved with more caution ? its upgrade from BB to BB+ brought Russia within one notch of investment grade status in January.
"Although there is still some discrepancy between the rating agencies, Russia is enjoying clear upgrade momentum, and barring any unforeseen disaster it will soon be an investment grade sovereign," says Andrew Dell, head of emerging market syndicate at ING in London.
That momentum has already had a quantifiable impact on demand for Russian Eurobonds, although bankers point out that a number of other factors are also playing into the hands of existing and prospective Russian borrowers.
Peter Malik, head of emerging markets origination at Credit Suisse First Boston in London, points out that with global issuance of corporate bonds light in 2004 for a variety of reasons, those elusive issuers that can offer investors anything in the way of extra yield now stand in a stronger position than they have for years.
"On the supply side Russian issuers are one of the few that can still offer yields of 7% to 9%, depending on the borrower," he says. "Investors in need of yield have few places to go other than the high yield market or into non-mainstream European corporate markets, and Russia is the number one market for them to look at."
That is especially true, he adds, now that opportunities in so many of the so-called convergence markets of central and eastern Europe have disappeared as a by-product of the expansion of the EU, scheduled for May 1.
"Corporate issuers in the accession countries did not represent a very meaningful volume, but they did provide a trickle of interesting assets for yield-hungry investors, and they have now dried up. All in all, Russian corporates are looking at a uniquely opportune time to enter the market," says Malik.
All these positive influences manifested themselves very clearly in the evolution of demand for Russian Eurobonds in 2003.
Reaching a mainstream audience
Above all, many bankers report that these currents have helped to transform the nature of the investor base that is prepared to absorb Russian risk. At the simplest level, it is now larger than it has ever been.
"The growth in the investor base for Russian Eurobonds has been huge," says Jonathan Brown, head of emerging market syndicate at JP Morgan in London. "In the same way that investors are looking at Turkey as a long-term accession play they are looking at Russia as an investment grade cross-over play, which is bringing in a much more diversified range of investors.
"Probably the one deal in which we noticed that phenomenon most clearly was the Gazprom euro-denominated transaction, which was huge for a euro deal."
When Deutsche Bank and UBS launched Gazprom's Eu1bn seven year bond in September, it instantly established a new landmark as the largest ever emerging market corporate bond in euros, and the longest from a Russian borrower.
Demand comfortably in excess of Eu3bn ? much of it from accounts that had never previously bought Gazprom ? meant the deal could be increased from an originally planned Eu750m and priced with no premium over Gazprom's existing 2013 dollar bond.
That benchmark transaction, too, had won plaudits for broadening the global demand for Russian bonds.
Launched in February 2003 by Dresdner Kleinwort Wasserstein and Morgan Stanley, the $1.75bn 10 year 144A deal generated some $6.5bn of demand, and half the paper was placed with US accounts.
Both those Gazprom deals were launched before Moody's surprise upgrade of Russia in October.
After the upgrade, the first investment grade bond to emerge from Russia was a $1bn three year FRN from Sberbank, led by UBS.
Richard Luddington, head of CEMEA debt capital markets at UBS, recalls that the day Moody's announced the upgrade coincided with the opening of the Sberbank roadshow in Paris ? an obvious and unexpected bonus for the issuer.
"The immediate challenge was to ensure that Moody's gave the Sberbank bond the same rating as it had given to the government," says Luddington. "That was important in helping with the momentum of the transaction, although the bond perhaps came too quickly for many investment grade buyers to install lines for investing in Russia."
Many of those lines were, however, in place by December, when Vneshtorgbank (VTB) launched the first fixed rate investment grade bond from Russia.
The $500m five year issue, led by Deutsche Bank and UBS, was unfortunately timed, as it was launched soon after news had broken of the Yukos-Sibneft merger being put on hold.
Besides the growth in the size of the investor base for Russian bonds, Brown says that in 2003 a much more diverse range of investors took on exposure to Russia.
They included high yield and even high grade corporate bond investors.
"In the telecom sector, for example, we've seen some investors that buy western European companies starting to look at some of the Russian companies in their own right," he says. "MTS, Vimpelcom and Megafon are all very strong telecom stories that are generating good cash flows. So they stack up well, compared with some of the western European operators, and they offer a pick-up in yield."
Another notable development in recent months has been the expansion in demand for exposure to Russia among Asian investors.
Dell says that ING has been in the forefront of promoting Russian corporate bonds in this market.
"We've seen a lot more participation from Asia over the last year, and in the last few transactions that we've led, anything from 15% to 40% has been placed in Asia, which is substantial," he says.
While appetite for exposure to Russia is clearly expanding, some bankers say that there is plenty still to be done before participation by the biggest institutions becomes routine.
"When I think of mainstream buyers I think of the major Continental European and UK accounts, plus US high grade investors, and to a large extent, they have yet to be involved in the Russian market," says George Niedringhaus, head of emerging market syndicate at ABN Amro in London. "The bulk of demand is still coming from dedicated emerging market investors, hedge funds and private banking accounts."
A fresh batch of issuers
If diversification of demand for Russian Eurobonds has been one trend in recent months, another has been diversification of supply.
In sheer size of issuance, the Russian Eurobond market continues to be dominated by commodity producers, particularly Gazprom. But a refreshing development in 2003 was the arrival of new issuers in new industries.
For example, there has been a steady flow of deals from banks which would previously have been unheard of among international investors.
Newcomers such as Zenit Bank and UralSib Bank were able to make very well-received debuts in the summer as demand for all things Russian gathered momentum.
The arrest in July of Platon Lebedev, chairman of MFO Menatep, Yukos's majority shareholder ? and, still more sensationally, that of Yukos chairman Mikhail Khodorkovsky in October, left the market in an enforced lull.
But the parade of new issuers has begun again this year with inaugural deals from Nomos Bank, Bank Petrocommerce and IBG Nikoil Bank.
It was in May 2003, however, that the Russian market most vividly demonstrated that it was not all about oil, gas, telecoms and banks.
Granted, when Alrosa launched its debut transaction via ING that month it was, once again, a commodities play ? this time on diamonds.
Nevertheless, the freshness of the sector was one clear influence allowing this five year deal, priced at 550bp over US Treasuries, to be increased from $300m to $500m.
The following week saw more variety when Wimm-Bill-Dann, the producer of dairy goods and juice, came to the market with a modestly sized $150m five year 144A bond via UBS which attracted $800m of orders.
The significance of this deal was that it gave international bond investors one of their first plays on the vast Russian consumer market.
Bankers believe an increasingly wide range of companies will start to issue Eurobonds.
"As in any economy, there will be other sectors that come through to the market, be it food, retailing, autos, chemicals or whatever. The market will develop into a more normal one in which more industries are represented," says Malik at Credit Suisse First Boston.
That would obviously bring new opportunities for investors, particularly as many of these deals would prize open exposure to Russia's domestic economy of 145m people who are starting to explore the joys of consumer spending for the first time.
"We are constantly on the look-out for diversification away from oil and gas, and to give investors the opportunity of taking advantage of demographic trends and consumer demand," says Luddington at UBS.
Credit skills at a premium
But a more diverse market will also bring new challenges. At DrKW, Kivinen says this year's expected series of debut deals from borrowers in less well explored pockets of the economy will need more intensive credit analysis.
"This year we will see investors differentiating more between the established blue chip borrowers and some of the more marginal names that will only have been reporting for a few years," he says. "In other words, we will see many more credit-intensive names coming to the market."
The need for increasingly intensive due diligence is something to which investors in the Russian market are more alive than ever, since the exposure of the shenanigans at Yukos.
But investment bankers appear to be happy that the excesses there are an exception rather than a rule, and should not be taken as a barometer of Russian attitudes towards corporate governance.
"I think the Russian corporate sector is recognising that it now pays them more to be clean than to be crooks," says one banker, "which is why we're seeing so many companies publishing IAS or US GAAP numbers and generally trying to behave like any Western blue chip company."
Another potential challenge associated with the arrival of a broader range of Russian issuers would be borrowers behaving like London buses ? or all arriving at once.
As Kivinen says, the most popular time for issuance will probably be in the aftermath of the earnings reporting season, which stretches between the end of March and June.
Observance of a well-disciplined issuance procedure will therefore be necessary if the primary market is to avoid becoming cluttered.
For smaller companies that are well known to the Russian consumer but have zero international name recognition, a much better funding option may be to explore the increasingly liquid domestic bond market, which is enjoying something of a renaissance.
The clearest evidence came at the beginning of February, when Gazprom launched a R10bn three year deal via Renaissance Capital and the Industrial and Construction Bank of St Petersburg, which was the largest bond ever issued in the domestic market and carried a juicy 8% coupon.
Investment bankers agree that the domestic market is likely to appeal more to borrowers as liquidity grows, although they add that it has obvious limitations.
Foremost among these is maturity. As Malik at CSFB says, although Russia's investment management industry is expanding, the market remains dominated by bank investors, which are usually reluctant to go much beyond five or seven years.
ABN Amro's Niedringhaus agrees that there are clear signs that domestic investors are becoming more demanding and sophisticated, with a growing appetite for corporate bonds.
But he adds that borrowers are likely to see the domestic market as an increasingly useful complement to international funding, rather than a replacement.
For the time being, therefore, Russian issuers will probably continue to focus on the much broader opportunities available to them in the international market, which bring a degree of cachet as well as funding.
Sovereign keeps its distance
Whether or not the most prestigious Russian borrower of them all will be adding to the supply is a topic of lively debate.
From a purely economic perspective, the Russian government has no need to tap international markets.
Indeed, with oil prices above the $30 a barrel mark, Russia is enjoying something of an embarras des richesses.
Bankers are only half joking when they say their data on the Federation's foreign currency reserves is probably out of date by the time it reaches them.
According to research published in February by Renaissance Capital, in December and January alone, Russia's foreign reserves expanded by a "quite remarkable" $15bn.
To put that total in perspective, Renaissance says it is "a sum roughly equivalent to 30% of the outstanding monetary base."
Against that backdrop, the notion that Russia might soon pass its cap around international investors in search of a paltry $1bn or $2bn sounds ludicrous.
There will, of course, be no shortage of investment bankers landing at the new Domodedovo Airport clutching briefcases stuffed with splendid case studies explaining how a sovereign benchmark increases the efficiency and liquidity of a corporate market.
At a stretch, there may be something in that argument, but not nearly enough, in the view of most bankers, to persuade Russia that it needs to return to the international bond market.
"Some investment bankers will be doing their utmost to persuade Russia to do a benchmark deal," says ING's Dell. "After all, a mandate from the Russian Federation would be terrifically prestigious and one of the easiest in the world to execute. But I can't see the necessity for the government to do a bond."
Dell firmly rejects the suggestion that in the absence of a sovereign benchmark, pricing at points in the curve where there is no government issue might be haphazard.
"That might create problems for inexperienced banks," he says. "But there are about four or five of us that are active in a very significant way in the market and I can't imagine any of us having problems in pricing Russian deals. At ING we've done nine Russian Eurobonds in the last 12 months, so we seem to have figured out how it should be done."
Perhaps. But some bankers caution that it would be unwise to rule out a Russian benchmark in 2004 altogether.
One points out that, with some $360bn of reserves, China had no economic need to tap the international bond market last year ? but it still launched deals of $1bn and Eu400m in a two-pronged fundraising in October.
Others add that the apparent political insensitivity of raising money internationally and handing chunky fees to overseas investment banks will be less of an issue now that the Presidential elections are out of the way.
They also say Russia may see some value in polishing up its profile in the international capital market before ? rather than after ? the US interest rate cycle turns, although as one banker puts it, even then a sovereign benchmark may be motivated more by "chest-pounding" than by economic logic.
Banks get into position
But even without a sovereign benchmark to compete for in 2004, or even in 2005, investment bankers will have plenty to keep themselves busy in Russia for the foreseeable future ? although it is not a market that is likely to be very rewarding for newcomers or suitcase bankers.
Deutsche Bank's recently completed acquisition of 40% of UFG, the first entry into the Russian investment banking industry by a Western player in the form of an acquisition since the turmoil of 1998, is very much an equity market story.
For the time being, most banks active in debt capital markets say they are channelling resources into building up local teams organically, rather than staking out potential acquisition targets.
"We are moving more DCM people to Moscow, because it's important to have people on the ground there permanently," says Brown at JP Morgan. "The dynamics of the Russian market are constantly changing and it's not the sort of market where you can succeed by just flying in and flying out again."