OFZs – liquidity’s new “safe haven” during Russian recession?

By bne IntelliNews October 1, 2015

Vadim Dumesh in Paris -


Russia’s cash-strapped government is on the hunt for cheap financing to plug the 3% federal budget deficit expected at the end of this year – and with oil prices low, and likely to remain there for years, the deficit could be a permanent feature for years to come. That’s why the state has come up with scheme to tap a hidden treasure trove of some RUB20 trillion ($306bn) of money – the people’s savings.

In a move that could boost Russia’s exchequer by tens of billions of dollars and partially dilute the effect of Western sanctions, the country’s largest banks, including state-controlled Sberbank, VTB and RusAgro, are reportedly ready to open special accounts for purchasing federal ruble OFZ bonds by retail clients.

A bill expanding access of the general public to OFZ bonds in 2016 will be submitted to parliament in the coming weeks, RIA Novosti reported on September 28, citing an unnamed federal official. According to various estimates, the government could generate RUB1 trillion to RUB1.5 trillion ($23bn) in sales by opening up the market for OFZs (Obligatsyi Federalnovo Zaima in Russian, or federal loan obligations).

The state doesn’t really have a choice. Cut off from international capital markets by the EU and US financial sanctions, the only source of funding available to both the state and companies is domestic resources (plus a limited amount of sovereign level loans from China and Middle Eastern sovereign wealth funds).

The Russian government is in much better shape than the companies. Thanks to the pre-crisis oil revenues, the state’s external debt is in single digits and it has never issued much foreign debt anyway: The Ministry of Finance used to issue $7bn worth of Eurobonds every year, more as a benchmarking exercise to make it easier to price Russian corporate Eurobond issues, than to raise money it actually needed. But even this borrowing has been cancelled for 2014-2016.

The story for corporates is very different. Russian banks, in particular, made heavy use of the global capital market where they could borrow long-term money at low rates, and then lend the money at home with shorter maturities and higher rates. But the international issuance of Russian bonds over the first six months of this year has fallen to next to nothing from several tens of billions in 2014 before the sanctions were imposed.

But even the government needs to borrow now, as the days of a triple surplus are behind us. And thanks to the high cost of borrowing, following an emergency rate hike forced on the Central Bank of Russia (CBR) by the collapse of oil prices in December, even the Ministry of Finance was struggling to sell OFZ to local investors at the start of the year. But after five successive rate cuts this year, which drove down the cost of borrowing price for the state, demand at the weekly auctions has picked up.

Previous unconfirmed reports claimed the finance ministry plans to expand the domestic borrowing programme to at least RUB1.1 trillion from the previously budgeted RUB800bn. Other reports say the fiscal squeeze could force the ministry to double OFZ issuance by another RUB1 trillion.

Relative safe haven

OFZs have proved an attractive and fairly priced instrument for both foreign and domestic investors, with one of the highest yields found in emerging markets, enabling investors and banks to invest excess liquidity left from strained crediting in the otherwise scarce long-term ruble debt market.

Russian OFZs now look like a “relative safe haven among peer emerging securities, as commodity prices seem to be stabilising and [the ruble] had already absorbed most of the external shocks”, believes VTB Bank's Maxim Korovin, along with other analysts.

“With the quality of assets rapidly declining on the market, OFZs remain the best option,” Evgeny Koshelev of Rosbank tells bne IntelliNews, adding that “their advantage is quality, liquidity and relative predictability”.

Despite ruble volatility, so far in 2015 OFZ demand was high from funds and particularly from banks looking to invest free capital, Koshelev adds.

And Alfa Bank analyst Ekaterina Leonova says that apart from attractive yields, ruble and oil price stabilisation, revived demand in the fall could be attributed to increased demand from foreign investors who prefer Russian debt to other emerging markets under pressure, such as Brazil and Turkey.

These were also the investors who boosted the OFZ market in the first quarter of 2013 when securities could first be registered on Euroclear, the world's largest settlement system for securities transactions, to process foreign nominee accounts.

The share of foreign investors in OFZs leapt to 30% after foreign investors were hooked into the Russian domestic capital market after Russian securities were added to the Euroclear system, but declined gradually to 20% in 2015 as sanctions took hold. The initial spike in foreign demand in 2013 saw RUB815bn of OFZ bonds placed out of RUB1.13 trillion proposed in 95 successful weekly auctions.

In 2014, OFZs also remained immune to rating downgrades amid the turbulent events in Ukraine. While Moody's and Standard & Poor’s downgraded Russia's foreign-currency rating to junk, the national currency rating remained at investment-grade level, allowing rating-sensitive institutional investors to maintain OFZ positions. The US and EU sanctions imposed on Russia for its annexation of Crimea and support for pro-Moscow separatists in East Ukraine also do not include a direct ban on acquiring Russian sovereign debt.

However, the ruble and financial market’s roiling last year led to a sharp drop in demand for OFZs. Russia’s finance ministry called off whole blocks of weekly OFZ auctions, and largely froze them in March, August, September and December of last year. Only six auctions were held in the last five months of 2014.

Facing higher interest rates, the ministry pledged not to borrow at over 10%, but in October 2014 it was forced to return to the market, despite rates approaching 10%, their highest point since 2009. Since autumn 2014, the rates on long-term issues were stable above 10%.

As a result, 2014 saw demand plummet to RUB384bn from over RUB2.5 trillion in 2013. The ministry offered RUB300bn but placed RUB158bn in only 26 successful auctions, compared with 95 in 2013.

Creative streak

After the 2014 slump, the finance ministry got creative in its use of OFZs when it cautiously returned to the market in late January, following the Central Bank of Russia’s (CBR) key interest rate cut from 17% to 15%, and the start of its monetary easing cycle.

This year the ministry introduced floating-rate and inflation-pegged bonds, direct off-the market sales to investors, and issued RUB1 trillion worth of OFZs to finance its bank recapitalisation programme.

Amid the ruble’s recovery and expectations of curbed inflation, new floating-rate bonds (“floaters”) promised high yields for first coupons while the key interest rate was still high, and preceding the OFZ rally in the end of Q1/15.

In late spring, as inflation expectations declined and with further key interest rate cuts by the CBR likely, investors switched back to long-term fixed-rate bonds to lock in the interest rate difference (the yields on long 10-year OFZ drop from about 14% to 11% by the end of spring 2015).

As demand slowed in the summer, the ministry responded by selling RUB50bn-60bn ($1bn) directly to Chinese investors and placing RUB75bn of OFZ-IN inflation-pegged bonds with a real guaranteed yield of 2%, “an attractive offer for the Russian debt market”, Uralsib analysts said, as another RUB75bn of inflation-pegged bonds were placed by the end of 2015.

Following good off-the-auction placements in July and better-than-expected fiscal performance, placements tailed off again in August when the finance ministry did not offer large premiums and the ruble slid again.

In total, RUB433bn in bonds were placed in 56 successful auctions, out of RUB521bn proposed and demand of RUB1.23 trillion, as of September 16, 2015, not counting off-the market RUB50bn-60bn placements and RUB75bn inflation-pegged bonds.

Stable prospects down the road

“OFZ still is the most liquid part of Russian debt market, bearing only sovereign risk and proposing attractive yields,” Alfa Bank's Leonova tells bne IntelliNews by email.

Foreign currency placements are closed off by sanctions, while the ruble debt is squeezed by yields many borrowers cannot afford and by lower demand in credit due to economic slowdown, Leonova notes.

On the demand side, there are many investors (pension funds, asset managers, investment funds) that want to protect excess resources from revaluation, she adds. Since spring these have been actively buying out OFZ auctions, ready to hold the securities through maturity. “As long as the ruble is stable, OFZs will continue to be demanded,” Rosbank wrote on September 24, predicting that demand will fall when the currency fluctuates and then recover once it stabilises, even at lower levels. The bank notes that most yield movement is observed for bonds with over five years maturity.

VTB Capital also now recommends buying into the five-year OFZs, noting that issues on the longer side look expensive compared with mid-term issues and that liquidity in the longer bonds is limited.

Overall, yields for OFZ issues are widely expected to converge towards 10% by the end of the year following the central bank’s interest rate cuts. This might be delayed, however, following September's pause in cutting the key interest rate from the current 11%.

Digging at the RUB20 trillion stash

In opening up this segment to the general public, OFZs have good prospects for attracting some of the RUB20 trillion in clients’ deposits stashed in Russian banks.

Currently, 2- to 3-year OFZs propose a yield of 11.3-11.4%, while deposit rates in Russia’s top-10 banks do not exceed 10.5%. However, the bonds remain a rather volatile instrument due to long maturities, which might periodically show yields both significantly higher and lower than average deposit rates.

Over-borrowing on OFZs would come at the cost of corporate ruble issuers that already have no Western capital market access due to the sanctions, face restrictively high yields on ruble debt, and might see lower liquidity due to the prolongation of the pension savings transfer moratorium.

The government is also bearing a much higher cost servicing domestic debt. According to the September 23 report of the Chamber of Accounts, the average yields of state ruble securities increased from 7% in 2012 and 7.7% in 2013 to 10.6% in 2014 and 12.5% in the first eight months of 2015.

The costs of domestic debt servicing in the federal budget jumped by 58.2% in 2012-2014 to RUB415.6bn.

The effect of raising an extra RUB1 trillion from the general public “will be extremely negative”, Robsbank’s Koshelev warns, as “the market is getting very nervous about the big volumes of the offer”.

The analyst reminds that selling additional large amounts of OFZs would require further signals on easing policies from the CBR, no volatility on the currency market, and possibly regulatory measures such as setting a minimum required OFZ amount for pension funds' capital.

Alfa Bank's Leonova does not see an extra RUB1 trillion in OFZ issues in 2016 as threatening, reminding that the placements will be spread evenly throughout the year and could be cut should market conditions change.


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