Russia: Great expectations

RUSSIA: THE NEXT CHAPTER

Russia’s central bank is preparing to set up a domestic corporate bond market to make it easier for companies to raise funds – as well as to consolidate the country’s large but unruly promissory note market.

The market for veksels, as promissory notes are known in Russia, is estimated to be as large as $90 billion, making it nearly twice the size of the government securities market. Daily turnover in veksels regularly exceeds $1 billion.

The market has taken off since the decline in short-term treasury bill (GKO) yields, which have fallen at the six-month maturity from 75% to 17%. Promissory notes issued by Russian companies and banks yield from about 25% to 100% at maturities of between two and six months, reflecting the extra risk of pure corporate debt.

Following the lead of Poland and the Czech Republic, the Russian central bank is launching in the autumn a pilot programme for a secured corporate debt market.

Andrei Kozlov, deputy chairman of the Russian Central Bank (RCB), says the project is a response to the tremendous financing needs of Russian companies and the interest shown mainly by domestic investors in the market for veksels. The new rouble bonds will be targeted at domestic investors, but foreign investors will also have access under the same system used to invest in GKOs.

“We are proposing a new type of financial instrument,” says Kozlov. “By September or October the first new bond issues – from about 10 or so of the largest Russian companies – should appear, underwritten by Russian banks.”

The market may eventually feature paper from 300 Russian companies in a trading environment as transparent as the GKO market, notes Kozlov. The bonds could eventually be rated by Russian and international agencies.

The corporate bonds will probably be traded on the stock market section of the Moscow Interbank Currency Exchange (Micex), the main venue in Russia for GKO trading. This would give investors the same centralized depository and electronic settlement mechanism as for GKOs.

According to the central bank, the first issues will have one-year maturities and the pilot programme will be fully implemented over the next 18 months. But more sceptical observers view the central bank’s announcement as an attempt to stake out turf in the regulatory struggle for the capital markets between it, the Federal Securities Commission and the ministry of finance. The central bank has not revealed specific plans since the announcement three months ago.

“I haven’t noticed that the organizers have been preparing an extensive programme since the original announcement,” says Denis Smyslov, investment director at Global Fund Management, a Moscow-based asset management company specializing in fixed income. “Either they are maintaining very tight-lipped discussions or they are not giving much thought to the issues.”

But the need for a corporate debt market remains. And the goal of central bank officials is to cooperate with the Federal Securities Commission – which will register the bond issues – to regulate the risky but high-yielding veksel market. Veksels have been used as a substitute for cash for several years by Russian companies and banks trapped in the non-payments crisis. The objective is to build up a chain of payments without using cash. And the companies expect their veksels will return to them as payments from debtors.

The government hopes that once a corporate rouble bond market gathers momentum, that these loosely regulated instruments will be integrated into a regulated bond market that will provide an important impetus for corporate debt financing.

The remarkable rally this year in prices for Russia’s main government securities – the short-term GKOs and the longer-maturing OFZs – has pushed nominal yields for the benchmark six-month notes down to 17% from about 75% one year ago. The increasingly positive macro-economic environment in Russia, combined with the recent strength of the rouble, is expected to lead to further reductions in GKO yields.

The low yields have fuelled foreign and domestic investors’ interest in alternative rouble-denominated fixed-income instruments. Foreign investors may be drawn to a corporate bond market that will offer higher yields than GKOs, even if the risk is higher.

Foreign investor interest in the veksel market is important in gauging potential investor interest in a market for rouble corporate bonds. The first fund giving western investors hassle-free access to the veksel market was launched in April by ICFI, the investment banking affiliate of Unexim Bank. The closed-end ICFI Corporate Securities Fund, listed in Dublin, may also invest in rouble corporate bonds when they become available and if the yields are attractive. A total of $16 million has been drawn into the fund and as much as $25 million is expected to flow in by the end of the year.

“Some large hedge funds have been eager to explore the veksel market for the higher yields,” says Robert Franklin, who manages the ICFI fund from New York. “They might be interested in corporate bonds, but the yields would need to be higher than the prospective yields that are being discussed. Most of the interest will come from domestic banks and Russian subsidiaries of foreign banks. These guys are interested if they can fund at GKO levels, then buy at 1,000 basis points over GKOs.”

Franklin thinks foreign investors will show interest as they become more familiar with the issuers and the settlement system. But he doesn’t believe funds will flow out of GKOs and into alternative rouble-denominated debt instruments, such as corporate bonds. “Corporate bonds are less an arbitrage and macro play and more a micro credit play. As GKO yields continue to fall, this money will mainly go into the equity market rather than the municipal or corporate bond markets.”

The link between corporate bonds and veksels troubles some analysts. “Corporate debt is a way for the government to subsidize loss-making companies which are insolvent and have not been closed down,” says Smyslov at Global Fund Management. “If the government tries to restructure the debt of insolvent companies, they may not be able to pay. If these companies are solid, such as Lukoil or Gazprom, they will probably trade at a discount to GKOs and wouldn’t lure investors from the GKO market.”

There will also be considerably more risk in a corporate bond market than in GKOs that may not be soothed by prospective yields of 20%-25% for the larger companies. Many of Russia’s blue-chip companies are responsible for the largest outstanding debts in the economy since non-payments wreck the cashflow of many of these companies.

Even Lukoil’s ability to redeem bonds, for example, would largely depend on the cashflow of companies that owe it money.

The central bank has announced that the bonds will be guaranteed by Russian banks. But Smyslov points out that if Russian banks start guaranteeing substantial issues of debt, their shaky liquidity would be put at risk. Russia’s top banks may appear solid as they build empires by acquiring whole companies from the government, but they depend on substantial resources from international investors.

Rouble-denominated corporate bonds would be more attractive to investors if they were convertible into shares, Smyslov believes. But since the amount of debt is so high, the shares required to back convertible bonds would be substantial. “I don’t think they will have huge success with a corporate bond market without brilliant and creative ideas on how to convert the bonds into shares,” he says.

Many Russian blue-chip companies such as UES, Mosenergo, Gazprom and Rostelekom plan Eurobond issues as a cheaper source of financing relative to domestic bank loans and share issues. But, according to fixed-income analyst Andrei Yashchenko at the Moscow-based investment bank United City Bank, the Eurobond plans announced by dozens of Russian companies are unrealistic. He predicts the strengthening rouble and an undercapitalized banking system will result in the domestic corporate bond market developing faster than is expected.

A thriving corporate bond market should have a strong appeal for issuers and offer an additional funding source to bank loans and Eurobonds, according to Alan Apter, a managing director of Renaissance Capital in Moscow. Apter outlined several advantages that corporate bonds would have over Eurobonds in a recent presentation in London. The rouble bonds would reduce exposure to exchange rate fluctuations, have less stringent disclosure requirements and lower expenses.

But even before the launch of a corporate bond market, corporate bonds representing restructured tax debts will reach the market. The government issued a decree in March on federal tax debt restructuring that offers tax debtors long-term restructuring at a favourable interest rate. Companies can choose to issue either bonds on defaulted debt or shares as collateral.

The oil holding Yukos was the first to use the bond issue for its heavily indebted oil-production subsidiary, Yuganskneftegaz. The government now plans to sell the bond on the open market, which will feature a two-year maturity and payment guaranteed by Yukos. Other companies are likely to choose the bond issue alternative since it gives them an opportunity to buy back their debt at a significant discount and doesn’t dilute the holdings of existing shareholders.