Ben Aris in Moscow -

Fixed income

"The best times for the fixed income market are over," believes Clement of Goldman Sachs.

Russian equity prices have reflected the soggy sentiment in Europe, however Russian bonds have largely decoupled from the fear stalking Europe on the back of Russia's extremely solid macro fundamentals.

Yield hungry investors have driven a boom in Russian debt in 2012, which is likely to continue well into 2013. But this has only been available to the top 20 names and as yields are driven downwards enthusiasm was waning in the best bonds as the year drew to an end. Analysts are speculating that the returns on sovereigns especially could fall in 2013, but investors will be on the hunt for new stories in 2013 that will drive them into different asset classes in the fixed income world in 2013.

"Unfortunately, bondholders can hardly expect 2012's heights to continue in 2013. Of course, opportunities exist, but we doubt that high results can be achieved using a buy-and-hold strategy for benchmark instruments. Spreads and nominal yields are very low, so further significant compression seems unlikely," Alexander Kudrin, a fixed income analyst with VTB, said in a note.

Russia'30's spread over the US10Y is unlikely to be tighter than 100 bps, predicts Uralsib, adding yields on Russia's longest bond falling to 3.25% by the end of 2013 - less than half what it was in 2011. "The expected return [on the Russia30s] is still likely to be positive, albeit lower than 2012," Uralsib said in a note.

With the return on Russia's blue chips and sovereign bonds falling investors are likely to start moving into less well-known names.

"Given narrow spreads and low nominal yields on benchmark Eurobonds, we see many opportunities for low-rated or second-tier borrowers to tap the market with new issues, as well as room for further spread tightening for these issuers on the secondary market. Overall, we see a high chance of a "hunt for yields" opening on the market in the beginning of 2013," says VTB's Kudrin. "We believe that the market will at least make an attempt to leap above 2012's high bar in terms of performance. Nothing is impossible, but investors would need to use new approaches and/or instruments to replicate 2012's success," says VTB's Kudrin.

At the same time international issues should give way to a rise in investment in the ruble bond market - aided by the increasingly easy access to Russia's capital markets thanks to the ongoing capital market reforms. This section of the market was on fire in 2012 with the total amount of corporate bonds placed (excluding technical deals) in 11 months of the year at RUB879bn, versus RUB700bn in 2011, and October was the most active month in the market's history (RUB271bn). Investors will have unfettered access to the Russian fixed income market sometime between January and March 2013 and investors in London and New York are already upping their Russian allocations.

"Another more or less obvious way of adding risk to positions is to increase local currency assets. In the CIS space, the most interesting opportunity is the Russian ruble bond market. From a fundamental point of view, there is reason to expect interest rates will decline as inflation is likely to decelerate. Furthermore, with strong oil prices, most investors are not afraid of ruble devaluation, and nominal interest rates are relatively high (about 7% for long-term bonds), which has pushed these bonds onto investors' radar," says Kudrin.

VTB estimates an addition $15bn-$20bn could arrive in the Russian bond market simply as a technical rebalancing after Russia's weighting in the international rankings is increased as a result of its hook up with Euroclear.

"The market's size -- $98bn in sovereign OFZ and $132bn in local ruble corporate bonds -- is large enough to fit the liquidity requirements of even jumbo international investors," says VTB's Kudrin.

Despite the relatively benign long-term trends, 2013 has two bumps in the road in the first half of the year. Traditionally the bulk of bond payments come at the end of the year, but the way things have worked out in 2013 there are big redemptions due in March that could soak up a large part of Russia's country allocations amongst investors due to the high demand for refinancing. This could reverse the trend of falling yields for new issues.

The second bump is due to the purchase of oil major TNK by state-owned Rosneft in September 2012; Rosneft says it will raise some $30bn-35bn in 2013 to pay off the oligarch owners of a 50% stake in TNK, which will also suck up Russia allocations.

The government is also due to issue another $7bn of foreign currency Eurobonds in 2013, however, as it can now source this from foreigners coming in via the local market it will probably raise this amount at home. Nevertheless the state is very interested in extending the Russian benchmark yield curve and so analysts believe the Ministry of Finance could try and issue 30 year or even 100 year bonds in 2013.

Having said all this, analysts are at pains to point out that the market remains very volatile and that an shock from the outside could have the effect of shutting down the primary market and causing a very painful correction; the bond market saw sharp sell offs already in 2010 and in the spring of 2011 due to Eurowobbles.

Corporate bonds

If sovereign and quango Eurobonds were the rage in 2012, then it is likely that Russian domestic debt and corporate ruble bonds will be a hit in 2013.

Russian corporate issuers are due to sell $35bn of new Eurobonds in 2013. Due to the $7bn sovereign placement in March and subsequent corporate activity, the total size of the Russian Eurobond market expanded 25% in 10M12 to $190bn, $145bn of which is corporate risk (including banks).

However, the outlook for 2013 is not so bright. The banking sector is likely to grow 16% in 2013, compared with growth of about 25% in 2012.

As growth will not accelerate in the real economy, Russian businesses' demand for new borrowings will probably remain confined to refinancing needs.

Uralsib forecasts Russian corporate issuers to sell $35bn of new bonds in 2013. In addition, the Russian government could offer up to $6bn in external bonds next year; however, no specific plans have yet been announced.

Forex

Most EM governments are fixated on maintaining stable exchange rates and this Russia is the big exception: the CBR has switched over to inflation targeting and the ruble corridor has been expanded to the point where the currency is also free floating. This means that unlike other EM currencies the ruble is likely to appreciate in 2013.

"Bank Rossii widened the FX basket's trading band by 100 kopecks to 7 RUB in an attempt to boost the RUB's flexibility (±1%) in order to improve liquidity and the efficiency of monetary policy. The lower boundary now stands at 31.65 and the upper boundary at 38.65 (32.15-38.15 previously)," say analysts with Danske Bank. "We expect Bank Rossii to widen the band further by 100 kopecks in Q1 13 and again in H2 13."

Goldman is predicting that the ruble will trade at an average of RUB29/$, where as the Ministry of Finance believe it will be RUB34.4/$.

If all the oil money goes to the budget, then there will be a 1.7% of GDP hole in the federal budget to finance that will be financed by domestic borrowing on the order of RUB1 trillion, say Goldman, although this could be less if the state decides to release more money from the reserve fund.

Banks

All of Russia's companies have been impacted by the slowdown in the rest of the world and are turning in sub-par performances, and this is creating additional problems for Russia's banking sector.

Russia's saving grace for most companies is that the government has successfully sheltered the population from the worst of the international crisis: wages have continued to rise over the crisis period (and risen in real terms too), there was only a mild and short-lived devaluation, and no one of any significance went bust.

The result is the economy is increasingly been driven by consumption, which has propped up many businesses. However, in banking it is less of a good thing. Consumers have gone back to the credit fuelled shopping binge while companies remain maudlin.

The resulting lop-sided growth strikes to the heart of the challenges Russia will face in 2013 and achieving a more balanced growth is key to a sustained recovery for the country.

CAR falling, funding mismatch

The main drag on the banking sector in 2013 will be the lack of funding. As 2012 wore on, the CBR became the main source of funds used by banks to fuel the 40%-plus consumer borrowing binge.

This lending is not matched by the growth in retail deposits (up some 19%) nor in the growth of corporate deposits. At the same time companies are not borrowing which is holding back growth that would also restore the balance between retail and corporate banking businesses.

The CBR's decision to finance this borrowing is clearly designed to prop up growth, but it also introduces a danger as CBR funding is typically very short-term (7 days) where as the terms of the loans are much longer leading to a dangerous liabilities mis-match.

The problem is clear from the chart below that shows the banking sector was suffering from a dearth of funding as 2012 came to an end and that the CBR has become the dominate source of funds for the sector.

The solution is for banks to raise more capital, however that could be difficult unless equity markets reopen. Leading consumer orientated bank Promsvyzbank tried to float in November 2012, but couldn't pull it off and all of Russia's banks are going to face similar problems.

The alternative is to leverage up and borrow from the

International capital markets as banks did enthusiastically in the years before the crisis. However, that is also not happening, except at the very biggest state owned banks.

Deposits

The real solution to the lack of funding to finance the lending is to increase deposits to match lending rates, and while consumer deposits have been rising steadily - 66% of Russians now keep their money in a bank, up from 25% a decade ago - it is Russian companies that remain reluctant to deposit their cash with Russian banks.

Consumer loans overtook corporate lending for the first time ever in 2012, but while consumer loans did rise the main reason for this milestone was the fact that corporate lending has fallen to a third of its pre-crisis peak.

This reluctance to deposit is strange and testifies to the nerves Russian owners still feel as the ruble is currently a high yielding currency. The interests rates at the top 30 banks has risen to about 10% fro 8% while the currency is also expected to appreciate and inflation was running at 6.8% as the year closed. Yet Russians companies are still happier putting their cash on deposit at international banks where they earn much less than to bring it home and take the spread from high domestic interest rates.

Consumer lending & NPLs

The strength of the consumer lending is worrying the CBR about the possible decay in loan quality and it began to move in the last quarter to shore up the robustness of the sector by imposing stricter rules, bigger reserve requirements and also increasing the amount covered by the deposit insurance scheme from RUB700,000 to RUB1m (about $33,000).

Still, Russia's banking sector has mostly recovered from the crisis of 2008 and things like non-performing loans have been falling. On balance the assets of Russia's banking sector were growing by 25% in 2012 and the health of the sector improving unlike nearly every other country around Russia.

The CBR is trying to pull off the difficult trick of allowing banks to lend a lot to consumers to boost economic growth, but at the same time increase regulatory supervision so these wanton ways don't lead to yet another banking crisis. So far it has pulled this trick off, but as the sector's capital adequacy ratio falls from the current 13.3% down towards the mandatory minimum 10% of total liabilities 2013 is likely to prove a crunch year as the CBR will be forced to reign in growth in the banking sector fro prudential reasons.

, Confused picture for Russia Part 1

, Confused picture for Russia Part 2