Bonds

A SUPPLEMENT TO EUROMONEY

Both rouble and dollar-denominated fixed-income instruments have been enjoying increasing attention from Russian and foreign investors. The main fixed-income instruments and markets and the practical elements are outlined below.

Rouble bonds

GKOs are short-term zero-coupon Russian government Treasury bills. OFZs are coupon-bearing Federal Loan Bonds. Both are issued by the Russian finance ministry and are traded on the Moscow Inter Bank Currency Exchange (MICEX) as well as on five other currency exchanges connected with the MICEX and located in large regional cities. GKOs were introduced in May 1993 as non-inflationary instruments for financing the budget deficit. OFZs were introduced in June 1995 to complement the GKO market as an instrument with medium and long-term tenors.

The main characteristics of the GKO/OFZ markets are summarised in the table below.

Historically GKO yields have changed dramatically (from 350%-400% to 22%-31% p/a). The main reasons for such a shift were the introduction of the rouble-dollar corridor, the strict target-driven policy of the Central Bank of Russia (CBR) aimed at reducing the cost of borrowing, the reduction of perceived political risk with President Yeltsin’s re-election, and the admittance of non-residents to this market. The current average GKO yield to maturity is about 24%, while the three-month dollar yield is about 14%, if hedged. All trading takes place Monday through to Friday on MICEX, with the primary auctions being held on Wednesday.

The participation of non-residents has been an important influence on GKO yields over the last year. The GKO market became tremendously attractive for the international investors from the moment when the rouble/dollar corridor was introduced in July 1995. However, foreigners were only first allowed access to the primary GKO/OFZ market in February 1996. Despite the restrictions, around $2.8 billion were invested by mid-August. Since August 15, 1996 non-residents have been authorised to access both the primary and secondary markets, although some restrictions still remain. Now non-residents can open special rouble account ‘S’ with designated Russian banks (‘S’ accounts can only be opened by official dealers with capital of more than $30 million) and buy government securities at auctions or in the secondary market with funds transferred to these accounts. The repatriation of funds is allowed only through a three-month FX forward contact, a portion of which should be offset at the CBR at special rates. This enables the Russian central bank to influence rates.

Foreign participation is also limited in cash terms. The central Bank fixes these limits very month, usually fluctuating between $1 billion and $1.5 billion. In November due to soaring demand from non-resident investors the fixed limit of $1 billion was increased to $1.5 billion. In return the central bank guarantees non-residents who hold securities to maturity a certain dollar yield, though foreigners can earn more than this by trading actively in the secondary market.

Due to gradual liberalization of the market the guaranteed yield was reduced first from 19% to 16% and then to 13% and the proportion of forward deals which must be offset trimmed from 90% to 75%. On January 16, the guaranteed yield was further decreased to 12.5% and the offset amount cut to 65%. Non-resident participation is expected to grow as the CBR will gradually eliminate the remaining constraints. The official intention of the CBR is to abolish the restriction by the end of the year.

Non-residents are now active participants in the rouble fixed-income market. In January to February 1997 some $1-1.5 billion was invested each month. As of January 1, 17% of the GKO/OFZ market was held by non-residents. The recent introduction of a tax on GKO earnings made the instrument even more attractive for non-residents, since they can claim an exemption under double-taxation treaties. Currently non-residents are investing in the taxable papers, while local investors are the more active in the non-taxable issues market.

The rouble exposure can be hedged with dollar forward contacts available in the interbank market, dollar futures on MICEX and index Swaps settled in dollars; price volatility can be hedged by GKO futures on MICEX.

The introduction of new version of the MICEX trading system scheduled for late March will allow OTC trading within the first half of 1997. GKO prices are quoted on Reuters.

Dollar-denominated bonds

Russian ministry of finance (MinFin) bonds are dollar-denominated bonds issued on May 14 1993 as a result of a freeze on dollar deposits placed with Vnesheconombank in 1991. Five tranches of MinFin bonds with a total value of $8.7 billion are outstanding. Since their issuance, an increasingly liquid market in MinFin bonds has developed because they are easy to access, they can be used as collateral or in repo transactions and forwards and options, and they do have relatively attractive yields.

Strategies involving straddles, spread trading (going long one tranche and short another) and portfolio diversification between tranches can all be employed.

MinFin bonds yields were between 10% and 13% in February. They are influenced by domestic political and economic factors and like many of the other emerging markets dollar-denominated instruments, by US Treasury yields movements. However, there is also the addition of risk from players’ perceptions of the market’s infrastructure. For instance, the acceptance of Vneshtorgbank as a custodian, the threat of potential dilution and the state of health of President Yeltsin, and the issue of stolen bonds.

Since there are no restrictions for non-resident participants, foreign players are very active in the MinFin market, making up around half of the market holdings. Settlement is T+7 calender days.

Unlike GKOs, MinFin bonds can be used in repo transactions and can be lent or borrowed on. They also have collateral value. Forwards and options can also be traded on MinFin bonds.

Rouble promissory notes

Promissory notes, known as Veksel, are sold by a number of Russian banks and corporations, including ING Bank Eurasia. They may be denominated in roubles and dollars and can be bought freely either by Russian or foreign parties with a ‘T’ account with a local bank, or by Russian entities. Dollar-denominated promissory notes may be issued by Russian banks with a general license and may be sold to non-residents and domestic entities licensed by the CBR.

Promissory notes have terms with a minimum of three days. Although the promissory note has a similar function to a bank deposit, it has several advantages over deposits and other money market instruments, such as the fact it can be redeemed for cash roubles and there are full re-endorsement rights. It is an unconditional obligation of the issuer.

Promissory notes can be used as a collateral or pledge. Execution of collateral right does not require a court decision. Interest on rouble promissory notes is normally lower than on GKO usually pegged to interbank and money market rates.

Features of the GKO/OFZ bond market