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28 June 2013

Sovereign Eurobonds: has Russia missed its best chance?

The Russian sovereign is a notoriously inflexible and aggressive issuer – but a much sought-after client. It has yet to pull the trigger on its 2013 bond issue but could press ahead soon, betting on further US Treasury rate rises, or hold off, in anticipation of a fall. Francesca Young looks at how the country will deal with the challenge of EM volatility.

The Federation of Russia is the issuer that bankers and investors I love to hate. It prints huge liquid Eurobonds – when this year's eventually appears, it could be for around $7bn. But it also pays low fees, takes a long time deciding mandates and prints so tightly that it sometimes scuppers its own secondary market performance.

None of this usually seems to do it much harm. Investors cannot ignore the name and bankers still jump through as many hoops as it lakes to win mandates.

This year, however, the sovereign's inflexibility may have cost it dear even before it has released price guidance. Russia was originally expected to sell its Eurobond in the first quarter but pushed its plans back to the second quarter for reasons that bankers struggle to pinpoint. Analysis now reckon it may not issue until autumn.

It mandated banks in June – this year it is Barclays, Deutsche Bank, Royal Bank of Scotland, VTB, Gazprom-bank and Renaissance Capital that are being honoured. But rising US Treasury rates are forcing up the yield that it is likely to have to pay.

The catalyst for the latest bout of volatility was the indications fr om Federal Reserve chairman Ben Bernanke on May 22 that it could begin reducing quantitative easing this year if the US economic recovery gathered strength. Ten year Treasury yields spiked above 2% after his comments and had touched 2.18% by the start of June. Just one month earlier they had been at about 1.6%.

The sell-off picked up pace in late June, when Bernanke repeated the Fed's plans, adding that the country could look to stop QE altogether by the end of the first half of the year. The market turmoil has hit emerging market bonds particularly hard, but liquid sovereigns like Russia had suffered worst because their tighter spreads offered less cushion to absorb Treasury rises.

In early May, Russia's 2022s were trading at a yield of 2.8%. By the start of June, that yield had hit 3.5% and bankers at the time reckoned that about half of that widening was due to the shift in Treasuries. Some said that the sovereign might choose to wait to see if that might reverse, but the risk is that the opposite will happen.

Andrey Solovyev, global head of DCM for VTB Capital, told EuroWeek before the latest sell-off that his firm's advice was for the sovereign to come sooner rather than later, arguing that continued rate rises could change investors' views of EM in the second half of the year.

The historical context of the current yields makes decisions on timing not quite so dear-cut, however, Compared to where they have been in the past, Russian sovereign yields are still low, even with some selling pressure now. Its $2bn 2022s were placed in March 2012 at a coupon of 4.5% – and are still trading 100 bp below that.

In addition, the country has $480bn of FX reserves and so is under no pressure to issue. That, in turn, makes it unlikely to be willing to offer a juicy new issue premium whatever the market environment.

"The credit quality of the Russian sovereign is undisputed," says Vladimir Potapov, chief executive of VTB Capital Investment Management in Moscow. "After 2008 it was viewed as being in much better shape than many other countries, with no Eurobond defaults from it throughout the crisis. So the appetite for Russian sovereign debt this year will simply be linked to die yield it offers."

One at a time

Russia has become infamous for printing only one deal a year. After its $5.5bn dual tranche return-to-market trade in 2010, it sold a Rb90bn ($2.74bn) seven year in 2011 – a Rb40bn new issue and Rb50bn tap – and then a $7bn triple tranche Eurobond in 2012.

In 2010, its aggressive style was heavily criticised after the deal sold off by several points immediately after pricing. But its last two have been much better received.

"Russia's 2010 issue was tricky – the market was volatile and it was forced into it a little," says a banker who has been mandated for the upcoming deal. "The more recent two have been a lot smoother; the market environment has been better."

Some, such as Solovyev, say that it is important that the sovereign continues to stick to its strategy of doing all of its funding in one strike each year. "The market has got used to it doing one deal a year and that restraint helps pricing for its own debt and for corporate and FI issues from the country."

Michael Ganske, head of emerging markets at global fixed income specialist Rogge Global Partners, disagrees. He says it would be more investor friendly for Russia to become a frequent issuer and borrow smaller amounts throughout the year. And this year's volatility could provide Russia with the perfect reason to switch to this method.

It would be much better for the sovereign to spread out its bond issues throughout the year than to print a massive amount like S7bn in one go," he says. "Every year the secondary market sells off before the new issue because there's such a huge amount coming."

He argues there is no Investor friendly reason for the sovereign to print so much all in one go.

"Russia is a fantastic recovery story but it's made them arrogant about what they can do in the capital markets." he says. "The reason that they do their bond issue all in one go is because they can and its easy. It also gives them an advantage in some ways to not be viewed as a frequent issuer."

An origination official in London agrees that the main reason is convenience for the issuer. "Look how long it took to mandate for the deal this year," he says. "If that process was happening three times a year u would be laughable. The market will give them $7bn in one go, so why not just take it?"

The deadline for responses to the RFP for this years mandate was January' 10, but it was another six months until the banks were publicly mandated. It is not unusual for the process to be long for EM sovereigns, but Russia is seen as a sufficiently big and sophisticated issuer to be able to move faster and take advantage of market windows.

Euroclearability excitement

One thing bankers do agree on is that there is no pressing reason for Russia to diversify the currency of its bond issues. As an oil-based economy. Russia needs dollars more than any other foreign currency. And the dollar market also offers the deepest pool of liquidity.

"The sovereign plans to come to the market regularly and will probably look to do different currencies at some point, but it will probably only do that when it needs those other currencies." says ал origination official. "For the moment, the sovereign has done 10 and 30 year bonds and could look to develop its curve further in dollars."

However, the focus for the country's debt this year has not been on the dollar market but on the domestic. OFZs – medium and long-term Russian domestic government bonds –became Euroclearable in February, making it easier for foreigners to buy them.

This partly explains why yields on OFZs have fallen by more than 100bp, to below 7%, and over S40bn of foreign money is set to enter the Russian domestic market by the end of 2013. But as Denis Poryvay, an analyst at Raiffeisenbank International in Moscow explains. Euroclearability is not the only reason for the tightening of OFZs.

"The huge rally in OFZs was not just the effect of Euroclearability but also of US quantitative easing," he says. "There was a lot of speculative money that flowed into the local market to pick up a higher yield. Because of chat, though, there's no further yield tightening expected in OFZs."

For the sovereign, the domestic market cannot replace the attractions of dollar Eurobonds, however. "The sovereign is already an active issuer in domestic bonds, but it's still much cheaper for them to issue in dollars," says Ganske. "As Russia is a dollar-based commodity economy, it will continue issuing in both currencies."

Lots of oil, less governance

Despite improvements in the country's capital markets, Russia's credit story still has some obvious weak points – the fact that its economic fate is shackled to global oil prices is one.

In 2008 oil crashed to a low of S30.28 a barrel and Russia's bond markets were plunged into turmoil. The primary market shut up shop and the country spent its FX reserves propping up its banks and corporates as their yields spiked to double digit levels.

There was much talk at that time of the country diversifying from oil and gas to avoid a similar problem in the future. But little progress has been made. If the eurozone crisis reaches a messy conclusion, Russia's continued vulnerability to an oil price crash could be shown again.

Ganske notes, however, that a change in Russia's FX policy has helped. The government is now much more comfortable with a fluctuating rouble – and that means the country has the flexibility to soften moves in oil prices.

For example, if oil were lo fall from SI00 a barrel (wh ere it was at the start of June) to $80. Russia's central bank could halve that fall in rouble terms by simply allowing the currency to depreciate by 10%.

It also means that the country can effectively target inflation rather than fighting to keep the rouble stable." adds Ganske.

Many Russia-watchers argue that the biggest problem the sovereign faces in the market is questions over governance and the rule of law. Ganske agrees this is a much bigger problem than the dependency on oil or the perception of president Vladimir Putin as an autocrat. But he also worries about the increasing market dominance of government controlled entities.


Such a situation can, in turn, hurt the perception of the country as a credit. "If Russia could sort out these issues, FDI would go up and capital would come into the country, and that helps everything perform as an investment, including the sovereign."

Traditional EM investors no longer put Russia in the frontier market category, and it has benefited from the eurozone crisis as money has fled to the stronger EM names in search of yield at an acceptable risk. The current volatility is likely to push the country's yields up, but bankers hope this will encourage it to adopt more measures that would help bring down its spreads. If that happens, it will no longer seem fanciful to imagine it leaving the EM sector altogether. 


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