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Comment by Andrey Solovyev, Global Head of DCM at VTB Capital, for Global Capital

29 November 2018

Russia fires off €1bn bond amid 'new Cold War' fears

International uproar over Russia seizing three Ukrainian navy ships last weekend did not stop Russia selling a €1bn 2.875% 2025 bond on Tuesday. But investor fears are growing ever higher over the likelihood of further US sanctions on the country. Russia’s pivot away from dollars seems to indicate the same concerns. Francesca Young, Sam Kerr and Lewis McLellan report.

Russia seized three Ukrainian navy ships on Sunday, sparking civil unrest in Ukraine, driving the tension between the two countries back up and increasing chatter around further Western sanctions on Russia, which said that it was simply protecting its own borders.

“We just don’t see any light at the end of the tunnel for a normalisation of Russia’s relationship with the West,” said one EM fund manager in London. “If anything, things are getting worse. I’m genuinely worried we’re heading towards a new Cold War scenario.”

The €1bn Russia bond, sold this week through sole lead manager VTB Capital, drew much criticism for its timing. Several capital markets bankers made it clear that they believed the move was a show of strength and illustrated Russia's continued access to the capital markets, rather than a carefully thought-out selection of optimal timing for the bond.

“The timing and the choice of euros not dollars is two fingers to [US president Donald] Trump,” said one head of EM syndicate in London. “It’s saying ‘you can’t touch us, we can raise money anytime we want’. This was clearly a political statement.”

Sources close to the deal vehemently denied this, claiming that the sovereign had simply set a course to the bond markets and decided to continue rather than altering plans in light of the political situation. They said that Russia is concerned about worsening market conditions.

“The timing of the sovereign placement was nothing to do with Russia defying capital markets,” said Andrey Solovyev, global head of DCM for VTB Capital in Moscow. “The deal had been planned for a long time and was ready to go. Yes, we considered delaying to next week, but the geopolitical landscape is unpredictable and investors were saying they were interested in buying the bond, so we went ahead with it.”

Worse to come

As well as general market concerns of rising rates, trade wars and lower oil prices going into 2019, discussion around a further set of US sanctions on Russia is focused on preventing US investors from buying Russian sovereign bonds in the future. After a set of US sanctions in April that forced US investors to divest all holdings of aluminium producer Rusal’s debt — wiping half the value off those bonds immediately and causing a 10pt-15pt sell off in several other corporates as investors tried to second guess what would be next — fund managers remain nervous about the unpredictability of the US’s next move.

“Previously we were working on two assumptions,” said the fund manager in London. “The first was that the US wouldn’t do anything to hurt its own investors. The second was that the US wouldn’t do anything to massively hurt the commodity markets. But at the April sanctions, both those assumptions were proved wrong. Now we feel that the US isn’t necessarily making rational decisions, so nothing is safe. For example, we think the probability of the US banning the holding of existing Russian sovereign debt rather than just stopping new issues is very low, but we can’t rule it out and I don’t think Russian bond yields are reflecting that possibility.”

Other investors are more confident that the US is unlikely to make a big move on Russian sanctions soon.

“It’s a global chess game and the US’s main target right now is Iran,” said a fund manager in the US. “Saudi Arabia is playing nice by raising production to lower prices — like they did to help defeat the Soviet Union under Reagan — to put real squeeze on Iran. Iran’s ability to export has been crimped post November 1 and then what they can sell generates much less revenue. If the US was to put more sanctions on Russia, Russia would raise oil prices, and that messes with their main focus of dealing with Iran. So they have very minimal appetite to punish Russia further right now.”

Appetite for destruction

The book for Russia’s €1bn seven year bond was stated as “in excess of €1bn including joint lead manager interest” at the last update before pricing. After pricing, a source close to the deal said that “well over half the deal was sold to international investors” but syndicate bankers away from the note said this was unlikely to be the case.

“There is substantial Russian money in Cyprus, Switzerland and London,” said the head of EM syndicate in London. “We’ve done some asking around and can’t find any real demand from international accounts, so that kind of interest must have been quite small.”

The fund manager in London said that he did not participate in the note.

“Russia is a marmite credit,” he said. “You either love it or hate it. In my case, I love it but our lawyers hate it. That doesn’t mean that we have any kind of restriction on buying that paper, but it does mean that, when I want to, everything has to go past them. The country’s macro fundamentals are amazing — low debt, low inflation, and their central bank is on top of things. If it wasn’t for the political situation, it’d be flying.”

An investor in Saudi Arabia was more positive though.

“There are still opportunities to invest in Russia,” he said. “[Russian president Vladimir] Putin knows how to deal with Europe, and things will improve with the US. Lots of people are happy to continue to invest in Russia because they have confidence in the ability of Putin to maintain stability."

However, opportunities to buy Russian debt remain limited for the foreseeable future.

“Russian bank and corporate debt is something of a dying breed,” said the London fund manager. “We’re much more often hearing about debt buybacks now than new issues. Gazprombank just this week called some of its subordinated debt.”

However, speaking at VTB’s Russia Calling conference in Moscow this week, Putin said that the country is hoping to grow foreign investment to fund infrastructure and development programmes.

“We’ve been developing plans for large scale investments in our country,” he said. “From 2019-2021, we’ll be investing Rb2.3tr in infrastructure and our development programmes, focused on increasing our exports and advancing the growth of our digital economy. Despite the growth in investment, there will be no weakness in our budgetary policy. We hope to grow foreign investment to 25% of GDP.”

Solovyev said that there is still demand for Russia.

“People understand the Russia story,” he said. “There are good borrowers here and the bonds are paid back, but the market volumes won’t be as high as previously.”

Pivoting to euros

At the conference, Putin said that the country is de-dollarising.

“We don’t have a goal to move away from the dollar. The dollar is moving away from us,” said Putin. “There is a problem with instability in dollar payments, so we are forced to look at reserve currencies. We’re upping the proportion of our trade conducted in roubles. It’s not our will to move away from the dollar, but we’re obliged to in order to avoid sharp movements. We want something stable and predictable. We’re working on an alternative to Swift with our trade partners.”

But that movement away from dollars in the bond market is difficult given that EM funds are in general much more dollar focused.

The US fund manager said that he would be keen to look at Russian new issues in dollars, though said that he has limited appetite for euro bonds. But non-dollar deals are all that are on offer at the moment. The London fund manager agreed that this seems to be the trend.

“It looks like there is a co-ordinated effort among Russian issuers to walk away from dollars,” said the London fund manager.

The last dollar note printed from the country was the $4bn deal the sovereign sold in March before the April sanctions. Both the sovereign and Gazprom chose to sell euros this month while Rushydro issued roubles and dim sum.

“They’re clearly making some great efforts to lower the proportion of US investors in the country,” he said. “While in theory a US investor could buy euro paper, swapping the currency is so costly that unless you have a euro investment book, it really probably isn’t worth it. In dollars, for example, the Gazprom bond would go into the major EM indices, but in euros it doesn’t and because it’s investment grade it doesn’t go into the euro high yield indices either — US funds have a bias towards those two categories so the buyers end up largely being European funds.”

A second investor from Saudi Arabia said that Russia would eventually need to relent.

“Russia and Russian borrowers will need to come back to dollars,” he said. “Euros can’t replace it. Roubles can’t replace it. Lots of people have tried to leave dollars, but they always come back. They will need to fund in dollars sooner or later.”

Euros has been the more expensive option for Ba1/BBB-/BBB- rated Russia this week. The €1bn 2.875% 2025 bond was sold on Tuesday at 99.221 to yield 3%. That was the wide end of revised guidance of 2.875%-3%, which had been released earlier in the day after initial guidance of 3% area.

Russia's dollar 2026 bonds, which are six months longer than this new bond, swap into euros at just under 2.4%, said a source close to the deal. The six month maturity difference would account for around 8bp, putting fair value for the new deal at around 2.3%. The new deal was printed at 3%, indicating a 70bp spread between the two, though not all of that will have been a new issue premium as emerging market euro issues almost always print wider than dollars.

“On a swap basis, euros are more expensive than dollars, but the benefit is that it gives you a chance to diversify the investor base,” said Solovyev. “There’s perhaps only 10% overlap with the dollar investor base. Investors were keen for a sizable deal to get the best liquidity they could. Seven years was the best for the issuer’s profile.

“Euros has definitely become more popular for dollar borrowers,” he added. “It’s less exposed to US sanctions. Some Russian quasi sovereigns are looking at raising euros.”

But Riccardo Orcel, head of VTB's international operations, said that dim sum bonds should also now be a focus for Russian issuers.

“I believe Chinese yuan can gain in importance in terms of reserve and borrowing currency for Russian companies,” he told GlobalCapital. “VTB Capital arranged a CNH1.5bn Eurobond for RusHydro this month that generated good international demand. We will be working to bring new issuers to this currency.”

Uncertainty in IPOs

Meanwhile the future remains uncertain for Russian IPOs. The country has the potential to be one of the most vibrant equity markets, but despite several high quality companies seeking to float, Russian equities have not recovered since the April sanctions were imposed on the country. According to Dealogic, no Russian IPOs have been priced this year.

Behind the scenes though meetings have been taking place for a number of companies including property firm Samolet and IT services firm IBS IT.

But the most prominent hopeful for 2019 is Sibur, the country’s largest petrochemical company whose major shareholder, Leonid Mikhelson, is one of Russia’s richest men. GlobalCapital understands the company remains keen on listing next year despite the geopolitical uncertainty surrounding Russia — particularly since the Democrats won control of the US House of Representatives.

This week’s events in Ukraine have weighed on the minds of multiple issuers, according to a source in Moscow with links to several Russian

IPOs, including Sibur.

He said that companies were likely to meet in the first week of December to discuss IPO plans following the G20 meeting in Buenos Aries. But should Russia avoid more geopolitical heat in Argentina, he expects listings in Russia next year, with Sibur the most probable.

“Sibur is one of the more likely Russian IPOs next year, there is a commitment to do this and everybody understands that if there is an offering it will be the highest quality listing to come out of Russia next year,” he said. “If someone does come to list it will be Sibur and if the conditions are good enough the company will try, mainly because the preliminary feedback which it has received from investors has been excellent.”

There is a debate though whether Sibur will be able to attract enough international interest should global hostility towards Russia continue.

The company is understood to be looking at a Moscow-only listing initially but will float a sizeable chunk of the company should it decide to list.

A large offering will need Western support.

“In 2020, Sibur will be a company with $ 4.5bn of Ebitda and will probably want a valuation of $26bn-$30bn in market cap and that is an elephant in the room,” said Anastasia Levashova, portfolio manager for global emerging markets at Blackfriars Asset Management in London.

“The shareholders will likely want to float 10%-30% of the company, between $3bn and $9bn. But I think with the attitudes towards Russia among investors at the moment that might be a struggle.”

The source close to the deal acknowledged that Sibur would market itself to Western funds but noted that the deal would not be overly reliant on those accounts.

Sibur already has Chinese investors and will approach Asian investors during IPO marketing. It is also understood to be planning to target investors in the Middle East.

The company has already had meetings with investors and is understood to be certain that it can list and is of high enough quality that sanctions will not be too much of a problem.

It could also potentially sell a hefty chunk in the Russian market, and could attract a cornerstone investor.

"The best way for the company to place $3bn in the market is by applying to the Russian direct investment fund run by Kirill Dmitriev,” said Levashova. “It co-invests with other investors, often in the Gulf, who will perfectly understand and appreciate the uniqueness of Sibur’s case. I think Sibur could place shares with that vehicle and sell the remaining portion into the market."

The source close to the Sibur IPO said that a deal with the Dmitriev fund was an option for Sibur but only one of a number of options that it will consider. He added that there were several potential investors in Russia, given the recent repatriation of capital into the country and new regulations which will allow Russian pension funds to invest in IPOs, beginning next year.

"Sibur can cherry-pick from a number of options and it isn't that often a company of this quality looks to come to market."

The source confirmed that the deal could be up to $3bn but the final size had not been determined. It will likely to be between 10% and 15% of the company.

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