Masters of the EM universe

Masters of the EM universe
By Ben Aris in Berlin November 8, 2016

“Western politicians haven’t forgiven Russia for Crimea, but the markets have.” That was the reaction of one international bond trader to the news that the Russian government raised $1.25bn in a mere ten hours, almost exclusively from international investors, with a Eurobond issue in October.

The horrible politics dogging the Kremlin doesn’t seem to matter anymore. All the modern day ‘masters of the universe’ – the name coined by Tom Wolfe in his 1987 novel “The Bonfire of the Vanities” – are interested in was the yield; in a zero interest-rate world, the Russian 2026 bonds were just too good to pass up. The issue was six times oversubscribed, which allowed the yield to be cut to 3.90% from initial guidance of 3.99%, and the 4.75% when the first half of the offering raised $1.75bn in May. The top-up issue was priced at 106.75% of par to give the lower yield. 

“We saw huge demand from investors... Around 200 investors from the United States, Britain, Europe, Asia and Russia submitted their bids,” Finance Minister Anton Siluanov said in a statement. “Placement was done in less than 10 hours.”

The Russian 2026 issue was an increasingly rare dish to whet the appetite of international bond traders in an increasingly lean market. In much of the rest of Emerging Europe, yields have been compressed by a quantitative easing programme run by the European Central Bank (ECB), so most bonds in Central and Eastern Europe (CEE) are currently paying zero or even negative real yields. Governments and companies across Emerging Europe are rushing to lock in the historically low yields and bond issues are up 40% year to date, according to Citigroup. Emerging market (EM) debt in general is back in fashion thanks to the low global interest rates with a total of $80bn of debt issued this year already, up from the $70bn that was issued in all of last year, according to Capital Economics. But none of this is good news for institutional investors like pension funds that are struggling to find a decent “pick-up” – and that is good news for Russia.

Russian sovereign issues

The milder weather in the bond market comes as a welcome relief for Russia, which has to fill a large hole in its budget this year and probably the next three years, according to the draft three-year budget that has just been submitted to the Duma.

Russia’s Ministry of Finance expects to be RUB2.6 trillion ($32bn) short this year and the same amount next year. The state still has about the same amount in the reserve fund of oil money that was prudently put aside in the good times, but as it becomes clear the state’s RUB1 trillion privatisation programme will probably fail, the rainy day fund will probably be exhausted by next year. The easiest way of plugging the hole after that will be to borrow.

Russia has already raised $3bn in two tranches of the Russia 2026 Eurobonds this year, but the first was stymied by pressure from the US State Department. Moreover, Europe’s largest settlement house Euroclear hasn’t included the first tranche in its system, making it untradeable on exchange traded markets. The Kremlin had to lean on its oligarch and Chinese friends to get the issue away. However, both those constraints were absent with the October issue. “The law of sanctions is still the same, but the spirit has changed,” says Oleg Kouzmin, chief economist with Renaissance Capital in Moscow.

The international resolve to maintain the sanctions on Russia is crumbling slowly and the enthusiasm for the Russia 2026 Eurobond show that financiers, at least, have forgiven Russia its geopolitical sins. “Russia is trading like an investment grade country at the moment based on pricing, despite the fact that the rating agencies have downgraded it to junk,” Kouzmin adds.

While the amount raised is no way near enough to cover the budget deficit, the sovereign bond acts as an important benchmark for corporate issuers and highlights the demand for Russian debt.

Gazprom Neft the oil-producing arm of the state-owned energy behemoth issued a bond on August 24 that yields 9.4% – the lowest yield issued by any Russian corporate in the last two and half years. And only a few days after the second tranche of the Russia 2026s hit the market, high-end Russian property developer O1 came to market with a $350mn issue, while major Russian fertiliser producer EuroChem placed the new issue of its 3.5-year, $500mn dollar-denominated Eurobond on October 6. More companies are planning to follow suit as Russia’s bond boom gathers momentum, as bne has been reporting since June. In January-August, Russian banks and corporations issued $8.4bn in Eurobonds, up from $1.8bn in the same period last year.

The growing enthusiasm has already started to compress yields on Russian sovereign issues, helped along by the solid macroeconomic fundamentals, steadily falling inflation and the growing credibility of the Central Bank of Russia (CBR). Yields on the Russia 2026s had fallen 71 basis points since they were issued in May to 4.04% as of October 12.

“It’s not like Turkey where an investor needs to understand the domestic politics and the personalities; the Russian story can be understood in a few minutes,” claims Kouzmin. “The CBR’s ultraorthodox game plan is what bond traders learned in school – it’s text book stuff… The domestic inflation story has made Russian domestic bonds one of the best fixed-income stories in the last few years.”

Russian corporate external debt has given investors a healthy return of 11% this year, and last year it was the best performing bond market in the world, handing investors a 17% return. Russian financial institutions and non-financial corporations issued RUB1.1 trillion ($17bn) in new domestic bonds this year, which is slightly less than year ago. The amount of domestic issues that are tradable on Euroclear and so available to international investors is expected to at least double next year.

Low yields and high demand mean that the Russian government says it will be back in the market next year, returning to its traditional $7bn of annual Eurobond issues, according to Siluanov, market conditions permitting.

Plugging the deficit gap

Siluanov’s hope is to spin out the reserves for as long as possible, but that will depend on the price of oil. Kouzmin believes that if oil averages $40 this year and next year, then Russia will exhaust its reserve fund next year.

Russia’s federal budget deficit will probably come in at 3.7% of GDP or RUB2.6 trillion this year at $40 oil. With RUB1 trillion ($32bn) expected to be left in the reserve fund next year, the finance ministry will have to borrow another RUB1 trillion from the market, which is the current estimate in the new budget being debated now.

On the other hand, if the average oil prices rise to $50, then the deficit will be closer to 1.6% GDP or RUB1.4 trillion; after the last RUB1 trillion reserve fund money is used up, then the state will have to borrow another RUB400bn, on a par with this year’s budgeted RUB300bn of domestic borrowing. Even if the reserves fund is completely used up, the finance ministry still has a second National Welfare fund of $72bn that can be tapped to support the budget if need be, although that fund is nominally earmarked exclusively to support pension payments in the future.

“We can't endlessly spend our reserves,” Siluanov told an economic conference in October. The finance ministry will cut spending from the Reserve Fund to keep it at a “sufficient level” in the next three years, Siluanov said without elaborating, but implying his ministry intends to ramp up domestic borrowing.

That means more government bond issues, or the so-called OFZ (Obligatsyi Federal'novo Zaima, or Federal Loan Obligations). Included in the Euroclear system and also paying attractive yields, the OFZ have been a smash hit with international investors: currently the foreign ownership of Russia’s OFZ are at an all-time high of over $20bn.

Negative yields elsewhere

Bond investors are not so much running to Russia but away from the falling yields in the rest of Europe. The ECB’s QE programme has sent yields on many Central European bonds tumbling to zero or less.

“There are three CEE countries – Slovakia, Slovenia and Czech Republic – where yields are extremely low and even extension of maturity (buying long-term bonds) is unlikely to generate a positive yield in real terms,” says Juraj Kotian, head of CEE macro and fixed-income research at Erste Group and author of the bank’s fourth-quarter bond market report.

In those three out of eight CEE countries that Erste covers, yields up to six years maturity are negative. In Slovakia and the Czech Republic two-thirds of outstanding government securities are priced with negative or zero yields. In Slovenia it is about a third. In the remaining CEE countries only Eurobonds with a few months to maturity are priced at negative yields, but the bulk of outstanding government securities are priced at yields above 1.5%. One- to three-year Czech yields are even more negative than their German counterparts, partly because the Czech National Bank has carried out a policy of preventing the crown from appreciating against the euro for several years.

“Most countries are in the EU and some in the Eurozone, which makes them eligible for the ECB’s [Public Sector Purchase Programme]. That has led to a significant tightening of spreads for the ECB programme of eligible names,” says Marzena Fick, head of CEE debt capital markets for Citigroup in London. “Investors are also looking at other types of assets such as corporate issues, including single B-rated paper, that have a spread on the government paper to get some pick-up.” 

Some investors keep buying them because they need a certain portion of liquid assets in their portfolios and these bear a higher or less negative yields than overnight deposit rates or German bund yields, says Kotian, who also argues in his report that the ECB policy is “financial repression” – a cheap way for European government’s to reduce their burdensome debt at the expense of savers and institutional investors.

“In the CEE region we do not see central banks pushing yields down by buying government papers in large amounts, except for Slovakia and Slovenia which are part of the ECB’s QE programme,” says Kotian. “Nevertheless some signs of financial repression could be seen in Hungary where the central bank has been eliminating the key instruments for managing the liquidity and thus the financial sector has to put more liquidity into government bonds. In the past, the Hungarian central bank was even providing interest rate swaps to incentivize banks to buy long-dated paper. In Poland, government paper is exempted from the balance sheet tax, which gives them a strong advantage over other asset classes.”

While investors are struggling with where to put their money, governments are enjoying extremely low financing costs, or in some cases actually being paid to borrow money. “The low interest rate environment creates an undisputable transfer of wealth from creditors (households) to debtors (governments), with banks as intermediaries negatively hit as well because of constraints on passing low (or negative) deposit rates onto clients,” concludes Kotian.

Even if the rates on bonds are not actually negative in real terms, the demand for bonds that pay something above zero means issuers have taken to increasing the maturity of their bonds to the very long end of the yield curves, locking in low rates for several decades to come.

Next year, about €70bn out of €480bn in the government securities portfolios of CEE countries will be rolled over into new bonds. Falling interest rates on government debt have been saving a lot of money for governments: interest expenditures as a percent of GDP have been falling by 0.2 percentage point on average over the last two years in CEE, enabling some effortless fiscal consolidation for governments in the region, according to Erste.

Something is better than nothing

Bond traders are happier with Polish, Romanian, Croatian and Serbian bonds, which are more attractively priced, while Erste Bank notes that Hungarian bonds are beginning to look pricey.

In the case of Czech Republic the yields are below German bunds because of the strong likelihood for currency appreciation in the coming year, once the central bank abandons its weak crown policy. And although yields in Croatia, Romania, Hungary and Poland are close to their all-time lows, they are at least not negative and do not look so bad when compared to expected inflation.

RenCap’s Kouzmin says that even the low-yielding bonds are finding buyers. Many global fixed-income funds have their benchmarks marked at zero, according to Kouzmin, so the 2% that Polish bonds pay is enough to attract investment and are overweight in most global funds, while risky Russia is still underweight. EM fixed-income funds, on the other hand, find 2% is too low and so underweight Poland, but almost all are overweight Russia’s much more lucrative bonds.

Another factor keeping the bond markets going despite some bonds at negative yields is the “local bid” phenomenon. Hungary was recently upgraded to investment grade by the global rating agencies, but the change in status has had little impact on its bond market where the bonds are very aggressively priced. Part of the reason is that local banks with excess liquidity have to buy local bonds because bank deposits pay even less. The same phenomenon is seen in Russia where banks have been stocking up on forex due to the volatility in ruble exchange rates and prefer to hold the money in Russian sovereign Eurobonds if they can get them.

Many portfolio managers will face a dilemma next year on whether to extend the maturity in order to secure any positive yield and avoid a more or less certain short-term or mid-term loss stemming from buying bonds at negative yields, or place the liquidity at the central bank at a negative rate.

Maturity extension, therefore, just deepens the real losses stemming from investments in sovereign bonds. Nevertheless, maturity extension could be used to minimize the short-term losses or spread them over time, or as a hedge against a scenario in which yields fall even further or stay low for a long time. This could actually happen if inflation fails to pick up.

CEE issues and redemptions

And demand for any sort of bond will probably remain high next year, as governments are not planning to issue much fresh debt in 2017. In Hungary, Poland and Romania, forex bond redemptions are set to fall next year, while redemptions are going to be virtually zero for the Czech Republic, Slovakia and Slovenia in 2017.

Serbia and Croatia are the only countries to see increasing forex bond redemptions next year. However, these countries also issue forex bonds on the local market, while Serbia also seems to prefer bilateral deals versus bond issuance when it comes to forex refinancing.

Hungary is also likely to continue to refrain from forex issuance, significantly decreasing the likelihood of any near-term issuance. However, bond traders would snap up any issue denominated in euros, bankers tell bne, but the domestic issues that the government prefers less so due to the currency risk.

“The central bank has reduced its maneuvering space to act aggressively against currency depreciation. They can still intervene on the forex market, but large volume of interest rate swaps can limit the central bank in hiking interest rates in the future. The inflation target is set slightly higher in Hungary compared to regional peers, which means that the central bank can easily tolerate or even welcome some gradual depreciation of its currency,” says Erste’s Kotian.

As for the region’s total gross financing needs as a percentage of GDP, they will decline from 10.7% on average for this year to 9.9% on average next year, Erste says. As for forex redemptions, however, there will also be a slight decrease from 1.6% this year to 1.3% in 2017. All in an all, the pickings in CEE are slim and supply of new paper will be meagre.

Forced to choose, Kotian says that in Central Europe the most attractive bonds remain those from Poland. “Polish paper offers attractive yields across the whole curve. Short-dated papers generate even higher yields than worse rated Hungary or Romania,” he says.

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