Ben Seeder in Riga -

February 1 wasn't planned out as a special day for Russia's capital markets. But at 11:00am on an ordinary, frosty Wednesday morning, officials at the Ministry of Finance kicked off the auction of government bonds that are the culmination of more than three years of reform designed to transform Moscow into an international financial centre.

The sale of Ministry's OFZ bonds (Obligatzsiy Federalnie Zaimov) was just one of the routine auctions, but this issue stood out, as for the first time foreign investors who are not physically or legally present in Russia could join in the bidding. And they did - in droves. "It was clear from early that morning that there were a lot of bids coming in [on the OFZ auction] that were going to be lower than the target range set by the Ministry of Finance," says auction participant Kieran Curtis, emerging market bonds fund manager at Aviva Investors. "We got lucky, we got our order filled - we bid 8.25, which happened to be the average bid that day."

New rules that went into effect at the start of this year mean that OFZs can be bought over the counter (OTC) without the need to open brokerage accounts at Moscow's main exchange Micex. The still-incomplete liberalisation process meant a large number of foreign buyers took part in the auction for the first time. Demand was such that the Ministry of Finance sold RUB35bn (€887m) worth instead of the planned RUB1bn. Investors placed an unprecedented RUB192bn in bids, making the placement 5.5-times oversubscribed. "It was pretty spectacular demand, and the strange thing was 70-80% of the bids came from foreign investors," says a trader at Deutsche Bank. "Also, I've never seen such high demand for OFZs of this duration - 10 years."

Altogether, Russia raised over RUB70bn in the auctions on February 1 and 8, both massively oversubscribed. Analysts say the success of the placements is proof that the government's plan to broaden the investor base in the domestic government bond market is working.

Open doors

After running its first deficit in 10 years and the near catastrophe that the heavy exposure to foreign loans inflicted on the Russian economy when the 2008 crisis broke, the state has been ramming through a series of reforms that will deepen and broaden the domestic market. Over the last two years, the government has already switched to raising most of its financing from the domestic markets, but from this year the market will be more-or-less thrown open to yield-hungry foreign investors in the hope of tapping new international pools of capital.

Last year, President Dmitry Medvedev signed into law changes to the securities regulations aimed at freeing up offshore investors' access to the government bond market. And the success of the February 1 auction must come as extremely welcome news to the Kremlin. "Previously, foreign investors seeking Russian sovereign exposure required local broking accounts at Micex, and they needed local custody accounts. This could take months and even years to complete," says Martin Gregson, a spokesman for Euroclear. "That has now changed - the bonds can be bought OTC, and a Micex account is no longer required. This will allow many offshore investors access, and we think even more will gain access once OFZs are able to be settled through international depositaries, like Euroclear."

Aviva's Curtis, who helps manage £159bn in fixed income assets, says the red tape conspired to keep him out of the OFZ market for nearly three years. "We seemed to be spending a very long time to agree terms with the market participants," he says in a telephone interview with bne. "Your broker and custodian had to be the same institution; you could only trade the OFZ bonds on Micex; settlement was a pretty rigid t+0, so it required pre-funding."

Curtis says if you didn't want to wait, the only other option was to buy the Russia 2018 ruble Eurobond that traded OTC. But it traded around 100 basis points dearer than the Micex-listed OFZ equivalent. "A lot of managers weren't comfortable buying something so overpriced," Curtis says.

Now, some of the rules have been relaxed; true liberalisation is expected to come later this year, when the international depositary companies, such as Euroclear and Clearstream, are allowed access to the market. "When that happens, OFZs will trade on the same basis as dollar- or euro-denominated assets. OFZs will be just as accessible to foreign investors as local participants," says Dmitry Yakushin, a fixed-income trader at Renaissance Capital in Moscow.

"Even though true liberalisation hasn't happened yet, you can see the effects on the market - some foreign investors are already accessing OFZs and local traders and investors are speculating ahead of the expected full liberalisation," he says, adding that this led to a huge rally that began at the start of January and ended in February.

Yields on the back end are 70-80 basis points lower than last year, while average daily volume in OFZs has increased to around RUB7bn, from an average RUB3bn last year. The increased traffic in OFZs coincided with a strong rally in the ruble, from RUB32 per dollar on January 1, to RUB29.75 in early February.

Underweight

Foreign bond funds wanting exposure to Russian sovereign paper in rubles have largely been underweight OFZs because of their inability to buy on Micex. For those funds not keen on the Russian credit or municipal sector (which were accessible by foreigners), this led them to be heavily underweight the country. According to a research report from Credit Suisse, the average emerging markets debt fund allocates only 5% of its assets to Russia, compared with 11% for South Africa, almost 9% for Poland, and 8.5% for Turkey.

Aviva's Curtis agrees most foreign investors are considerably underweight Russia, but this is now expected to change. "I suspect that by the end of this year, you will see a much more neutral Russian position among foreign investors compared to their benchmarks," he says. "In our case, many of our funds are still very much underweight Russia, because we haven't been able to trade OTC with all of them yet. It's quite possible that by the end of the year, we will have an allocation that is well above neutral."

He says Russia's growing weight in emerging market bond indices, caused by a river of issuance over the last two years, is placing heavy pressure on foreign investors to bring their Russian positions back to a neutral allocation. "The appetite for Russian OFZ debt from foreign managers wanting to get back to neutral weighting is pretty large. Up until these reforms, managers haven't been able to do very much about [their underweight positions]".

Depending on the index used, Russia's weight varies from 6% to almost 10% of the index. One common benchmark is the JP Morgan GBI EM Global Diversified, where Russia accounts for 8.6%.

Curtis says the lower inflation in the country, which has moved real annual yields from negative five years ago to 2-3% currently, is also increasing the incentive for fund managers to return to Russian sovereign paper.

Other fund managers expressed similar sentiments. Marcelo Saez, a portfolio manager who helps manage £350m in emerging market debt at hedge fund Argo Capital Management, says he will probably double his allocation to Russia, from 5% of the portfolio to 10%, by the end of the year. "I think the ruble will have a lot of support this year because of the price of oil and the reforms in the market we are talking about now," he says.

Viktor Szabo, an emerging markets portfolio manager at Aberdeen Asset Management, who helps manage £4bn in emerging market debt, says: "In our local currency fund, we had this problem with OFZs being almost 9% of the benchmark, and we were not able to take any positions at all. We felt extremely uncomfortable with the underweight position, even though we are not that much in love with this country [as an investment case]." Until now, the fund has been forced to buy the only Russian ruble government bond available - the overpriced Russia 2018 10-year bond.

Paul Denoon, head of emerging market debt at New York-based AllianceBernstein, says the reform will give him the chance to put ruble exposure into a wider range of portfolios. "We already own some OFZs... we previously took the steps of setting up local custody and settlement arrangements. But we have a large array of portfolios and segregated accounts that, for whatever reason, cannot or will not handle local settlement of OFZs," says Denoon, who is in charge of around $19bn in emerging market debt.

For these accounts - especially the segregated institutional accounts of pension plans managed by AllianceBernstein - the move by the Russians to "Euroclearability" means they will gain access to the OFZ market for the first time, and Denoon expects he will increase exposure to the OFZ market in these funds in the future.

Denoon says the reform also coincides with a trend by US pension plans to hire asset managers in local currency emerging market bond mandates. According to US-based investment consultants NEPC and Intersec Research, at least $3bn in local currency emerging market debt institutional mandates went out during 2010-2011. Denoon says this increased interest in local currency exposure may lead to a surge by US institutional money into the OFZ market - especially since the interest in local currency exposure coincides with the Russian reform. Examples include the $48bn Massachusetts Pension Reserves Investment Board, which put out an RFP for a $900m local-currency emerging market bonds manager last year.

Sergei Strigo, head of emerging market debt at Amundi Asset management, says he could increase Russian exposure this year. "We like Russian assets - we have sovereign and corporate exposure, in dollars and rubles. Around 10% of the portfolio is in Russia, and I don't see that level decreasing; in fact I can see that our exposure might increase in the future."