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25.03.2008 - MDM Comment: Strategy comment on ruble bonds
(for the version with charts pls see attached pdf file)
At the risk of stating the obvious, we would like to make some brief strategy comments with regard to the ruble bond market.
We believe that local bond yields will continue to rise despite the fact the government and the Central Bank have prepared enough tools to avoid a ruble liquidity squeeze, providing hundreds of billions of rubles in short-term funding at 6.25-8.00% (via repo, Lombard loans, and deposits of Treasury cash balances). We think that short-term rates, or expectations with regard to those rates, are no longer the key driver of longer-term bond yields, at least for now.
Despite mild money market conditions in January-March, we have seen ruble bond yields rising quite substantially, already exceeding the levels of September-October 2007 when the liquidity shortage was acute and short-term ruble rates were rather high.
We believe that the key drivers of the yields are now threefold: a lack of long-term funding at local banks; the unwillingness of the core investor base to increase exposure to bonds; and finally, the still intense new supply.
A reversal of the current ruble bonds trend, in our view, is only possible once global risk appetite recovers and local banks return to pre-crisis levels of fundraising in the external wholesale capital markets.
Those markets have historically been the core source of long-term liquidity for Russian banks and corporates. Now, with availability of this source being significantly reduced, banks have had to scale back their balance sheet growth: they are not willing to – or simply cannot – pursue credit expansion based on short-term funding. Many local banks do not even want to buy bonds using the Central Bank’s leverage opportunities.
The reason behind the virtual shut down of the wholesale capital markets for Russian banks is no secret: Western financial institutions are recognizing heavy subprime-related losses. These losses have been partly offset by new capital injections, but the remainder has to be compensated by a severe contraction of balance sheets. That, combined with undermined inter-bank and client confidence, forces financial institutions to put any credit expansion on hold, regardless to how cheap the money offered by the Federal Reserve is. In fact, this is why, for the first time in at least 15 years, we are experiencing such a marked de-coupling of short-term USD rates and corporate bond yields.
Under these circumstances, Russian banks are forced to switch toward actively raising their deposit base. However, this is a far more expensive source of funding. It is also more time consuming to collect, and, fundamentally, deposits are still short-term (all deposits in Russia are still callable). This method is therefore not a true replacement for external wholesale funding. There is some long-term money in Russia, which includes the two sovereign wealth funds (resulting from the split of the Stabilization Fund) and the Pension Fund. However, the first cash pile has so far been invested outside of the country, while the bulk of pension assets can only be invested in sovereign bonds. There is a great deal of discussion on how the wealth fund and pension money may support the economy and financial system with longer-term funding, but we don’t foresee any quick decisions there, as the matter will require plenty of political and technical work before being decided.
It is also important to understand that in a stress scenario, Russian banks prefer to focus on their core business, commercial lending, even if the offerings in the bond market are more attractive from a risk/yield perspective. This is also, incidentally, why re-pricing of liquidity and risk is taking place at a far more rapid pace in the bond market than the commercial loans market.
For the reasons described above, neither Russian banks, nor the foreign investors are willing to increase exposure to ruble bonds. Simultaneously, the supply is still there. Many local corporates have not only scaled back their investments, but increased investment appetite. Facing restrictions in the loan market, some issue ruble bonds. For the ‘high grade’ issuers it makes sense. Given the current shape of the NDF curve, it is cheaper for B1/B+ and above rated corporates to pay 10-11% in rubles vs. paying 7-8% in USD. Since the Central Bank accepts bonds of B1/B+ rated issuers as a collateral in 6.25% repo transactions, the 9-11% yielding bonds are consumed by the local investor base.
Also, when talking of new supply, one has to not only look at brand new issues, but more importantly, at bonds that have puts with uncertain coupons beyond the put date. If the issuer doesn’t want to receive the bond back, it has to set up attractive coupons, offering a pick-up over secondary market levels. Approximately 250 issues, or 35% of all Russian bonds, have puts in 2008.
We believe that all this new supply will keep gradually pushing ruble bonds yields up, with re-pricing of loans to follow.
When it comes down to recommendations, we continue to recommend sticking to bonds maturing in less than 1 year. We advice those who can increase P&L by using leverage to play with the short-dated bonds from the Lombard list. Otherwise, look into multiple distressed debt opportunities (for now, our top picks here are Kopeyka at 17% or Pharmacy Chain 36.6 at 22%) as well as the new issues which have fully reflected the re-pricing of liquidity in their new coupons (URSA-related Oriental Express Bank at 14% or B2-rated Factoring Company Eurocommerce at 16%).
Appendix. Thoughts on external debt and related risk of capital outflow
There are plenty of discussions about the high volume of external debt due to be paid by Russian banks and corporates, and the related capital outflow, which may add to the challenges in the local money market. Below are our views on the matter.
We believe that not all external debt maturing in 2008 may be refinanced. Here is the math. The debt due to be repaid in 2008 by banks and corporates registered in Russia totals approximately USD118 bn. That is according to the official statistics provided by the Central Bank. This figure exaggerates the true size of the refinancing problem, as it includes sovereign debt, renewable bilateral lines, and, most importantly, it includes the debt funding provided to locally registered subsidiaries of foreign banks and corporates. The local subsidiaries of Unicredit, Citi, Raiffeisen, SocGen and many other international financial institutions have large balance sheets that are partly funded by the parent companies.
Having examined the debt due by Russian corporates and banks on Eurobonds and syndicated loans –around USD60 bn in 2008 – it is our belief that the true size of the refinancing problem is perhaps between the 60 and 118 billion mark, i.e. somewhere in the 80-90 billion range. The bulk of that is due from Russia’s top borrowers, with investment-grade or BB-category ratings.
Between January and March, Russian companies and banks have closed some USD 20 billion worth of new external debt deals. This debt was mostly comprised of syndicated loans raised by Rosneft, VimpelCom, RUSAL, Railways, Mechel and some other entities. At first glance, things appear to be on track, i.e. if we move at the pace of 20 billion per quarter, the whole amount of USD 80-90 billion will be refinanced. Still, as aforementioned, we see a risk this may not happen.
First, syndicated loan liquidity may not be as cheap and available going forward as the crisis develops and more liabilities and assets are re-priced. To date, those loans are worth far less compared to yields in the Eurobond market. Higher commissions and no mark-to-market risk do not explain the 1.5-4 percentage points difference in pricing. Second, many of the abovementioned corporates are not borrowing to refinance debt, but to fund expansion, often the acquisition of new assets. In cases when the seller of assets is not a Russia-based entity, these loans definitely don’t help to resolve the capital outflow problem.
Having said all that, we believe that this is not a serious problem for Russia at all. The potential negative difference in debt redemptions vs. refinancing will likely be offset by equity-related capital inflow and/or the strong positive trade balance that Russia still has due to stratospheric commodity prices. Finally, there are over USD500 bn of FX reserves at the Central Bank and a strong commitment from the Russian government to insulate the local economy from the challenges related to global credit and liquidity crisis.
