Russian Fixed Income Daily
- Putin: convertibility, demography, defence
- FOMC meeting: no real clue
- Mechel-SG put option approaching...

FX and money market

Yesterday, the rouble continued to appreciate and gained some five kopecks (tom rate reached RBL/USD27.03) following the strengthening of the euro, which touched USD/EUR1.28. In the evening, the Federal Reserve increased its rate by another 0.25pp to 5%, which frightened the euro to USD/EUR1.272-1.275. Consequently, the rouble has lost a couple of kopecks today and is currently trading around RBL/USD27.07-27.08. Today we do not expect any dramatic changes and see the rouble in the range RBL/USD27.06-27.13.
In the money market, the situation looks stable. Overnight rates are low at 1.5% and we do not expect any turbulence.

Julia Tsepliaeva, Moscow (7 495) 755 5489

Rouble bond market

Yesterday the domestic bond market was in consolidation ahead of the results of the FOMC meeting and so both price action and trading activity were slow: the government sector marginally strengthened on rising Treasuries, while municipal and corporate sectors saw some cautious profit-taking.
The spread of Russia’30 over US10Y is currently 107(+2)bp (relatively wide again, with a compression potential of 15bp from an historical standpoint), while the spread of OFZ 46018 over Russia’30 is 72(-3)bp (a new historical low, but wide in a medium-term perspective: our target for it is 50bp).

Quicker removal of domestic restrictions
The rouble convertibility by 1 July promised by President Putin in his parliamentary address means the end of reservation requirements for foreign holders of rouble bonds. After the changes come into effect, foreigners will definitely have better access to the domestic bond market, although some difficulties will remain: custody problems and taxation issues.
First of all, many foreign clients have the problem of having NDC of DKK as their custodian and simply do not know these institutions well enough. Secondly, a lot of foreigners cannot handle trading on MICEX and would like to see rouble bonds registered in Euroclear. Thirdly, the system of taxation of rouble bond income for foreigners is still very complicated.
As a result, the removal of reservation requirements does not mean that rouble bonds will immediately start trading as easily as Eurobonds. On the other hand, this step and its nearing implementation are increasing the relative upside of the rouble market relative to dollar Eurobonds. We have frequently stated that our assessment of the spread between long-term OFZs and Russia’30 is 50bp at the end of 2006. Now we can forecast that this level could be reached much earlier.

FOMC meeting: no real clue
The Fed raised its target rate by 25bp yesterday, but the accompanying comments did not clarify whether the rate would be raised once more at the next meeting on 29 June. Basically, the statement informed the public that another hike would be possible if further economic data indicated the possibility of an inflationary threat.
When the rate decision was published, US10Y made a large jump up in yield, but later stabilised at approximately where it started the day, i.e. at 5.13%. Also, July Fed funds futures were essentially unchanged at 5.1% showing that the market is assessing the probability of a pause in rate hikes in June as higher than that of another 25bp increase to 5.25%.
So far it looks like the next FOMC meeting has a strong chance to become the first in a couple of years for the market to be split in expectations regarding not only the comments, but the rate action itself. On the other hand, on the way towards 29 June we will see a lot of new data publications, several speeches from Bernanke, and probably most importantly, the minutes of 10 May FOMC meeting (due on 30 May), which may clarify the Fed’s future policy for the investment public.
Overall, the situation did not become clearer, but short-term rates are now 25bp higher, which makes US Treasuries more vulnerable in the short-term perspective.

Mechel-SG put option approaching
Recently Steel Group Mechel has set the coupon rate for the remaining three semiannual coupon periods of its outstanding RBL2bn bond Mechel-SG at 5.5%.
The paper will soon have a put option exercise (25 May), so investors will have to decide whether to keep the bond on position or sell it to the issuer.
It definitely looks as if the company wants to buy the outstanding paper back, as the new coupon rate is too low for the credit quality of Mechel: with it the paper yields at par 5.57% for 1.5 years, which is approximately where the NDF curve is currently located.
Therefore, bondholders on the whole have no choice but to exercise the put option of Mechel-SG.

Secondary trading
Price changes of high grade rouble bonds: OFZ 46018 +21bp, OFZ 46020 +0bp, Moscow-39 -5bp, Moscow-44 -20bp, FSK UES-2 -2bp, Gazprom-4 -40bp, Lukoil +24bp, RZhD-6 +6bp.
Second-tier papers: MosReg-6 -14bp, CenTel-4 -21bp, Kopeika-2 +14bp, Magnit -7bp, UTK-4 +5bp, WBD-2 -2bp.
After its primary placement on 25 April 2006, MosReg-6, a RBL12bn bond of Moscow Region, is trading at 7.6% to maturity in five years, i.e. notably above its fair value. In our weekly publication dedicated to the auction of MosReg-6, we outlined a YTM of 7.5% as fair for this paper, and as we still believe this to be the case, we recommend accumulating the paper above that point. Moscow Region is rated BB/Ba3 by S&P/Moody’s.
In addition, among long-term papers a bond of Rosselkhozbank, a quasi-sovereign entity specifically created by the Russian government to finance the agricultural sector, RSHBank-2 appears to be trading far above its fair yield. Currently, RSHBank-2 is at 7.98% to maturity in five years, while its fair point in the current market conditions is probably 7.75% and possibly lower in a long-term perspective. Even in adverse market conditions, this bond appears quite a relatively safe investment from a standpoint of interest-rate risk. Rosselkhozbank is rated Baa2/BBB- by Moody’s/Fitch.
UrSI-6 remains one of the highest-yielding telecoms bonds in the corporate sector, being located at 8.55% for 31 months. We would not say that this paper offers immediate upside, but it is definitely very well positioned to compensate holders for its credit risk. Uralsvyazinform is rated B+/B+ by S&P/Fitch.
We continue to recommend bonds of Russian Standard bank. Market participants should take a look at the RBL3bn RSB-4 located at around 8.5% to maturity in 23 months. We believe that this paper is at least 25bp above its fair point. Russian Standard bank is rated B+/Ba2 by S&P/Moody’s.
RusAl-3 was quoted yesterday at 7.75% YTM for 29 months. We estimate the long-term fair point for the paper to be 7.5%. Apart from simply having an attractive yield, we believe that RusAl-3 promises additional upside due to the expected transparency increase in 2006-2007 that Russian Aluminium promised investors in 2005.
TMK-3, a bond of the Russian tube industry leader TMK, was yesterday trading at 8.25% to put in 22 months. We believe that this bond is attractive as far as it pays a premium to the outstanding paper of its direct competitor, OMK-1 located at 8.1% for 25 months. In our opinion, the medium-term fair value of TMK-3 is 8% YTP, so we continue to recommend accumulating this paper.

Short-term market view
Our long-term view for the market is definitely positive based on the expectation of further spread compression between the OFZ curve and US Treasuries. The imminent removal of restrictions on foreign ownership of rouble bonds only strengthens this outlook. On the other hand, we should also not disregard the threat of further policy tightening in the United States and, correspondingly, higher yields of long-term US Treasuries – it is a very realistic scenario that US10Y reaches 5.5% before the end of 2006. So far, our recommendation for long rouble bonds remains a Hold in expectation of some short-term capital gains due to excess rouble liquidity and the reaction to Putin’s parliamentary speech.

Dmitry Dudkin, Moscow (7 495) 755 5480


Economic commentary
Putin’s Annual Address: convertibility, demography, defence
The rouble will be convertible from 1 July 2006; Petro-rouble?; New ambitious programmes to stimulate fertility announced.
Yesterday, President Putin addressed the Federal Council, making very important programme statements. Although there have been a lot of rumours that this year the annual address would be more focussed on foreign policy, Putin made demography, defence, and the convertibility of the rouble the most important topics of his speech.
Convertibility of the rouble: Putin said that the rouble would become fully convertible from 1 July 2006. This means that capital account operations will be fully liberalised (current account operations are absolutely free in Russia) already this year. Previously, this liberalisation had been scheduled for 1 January 2007 - as the DIRECT law on the Hard currency regulation and hard currency control indicates. Nevertheless, the CBR has not ruled out that it could abolish all restrictions on capital account operations earlier in 2006. The president very much likes the idea of making the rouble \'convertible\' earlier, in particular before the G8 summit in St. Petersburg. The liberalisation of capital account operations will be positive for the local debt market, in particular for its sovereign segment where the current norm of reservation is restrictive for non-residents (7.5% for a year period).
At the same time, the CBR is not going to switch to a fully floating exchange rate regime. Currently, it wants to keep the rouble linked to the bi-currency basket although its recent appreciation has raised some concerns. We do not expect any strong impact on exchange rates. As foreign demand for the rouble remains low, it is unlikely to become a means of payment or saving instrument like the dollar, the euro or the GBP – although many people have understood the president’s term ‘convertibility’ in exactly this sense.
Petro-roubles: Putin also announced an idea of how to stimulate foreign demand for roubles, saying that Russia should sell its commodities (oil, gas, metals and so on) on Russian exchanges and in roubles. Indeed, the materialisation of this idea would boost foreign demand for roubles, although we do not think that it is very realistic or that it could be practically implemented in the coming years to significantly impact commodity or FX markets.
Demography: This was the most crucial and popular part of Putin’s address, the proposals of which unsurprisingly were met very positively. Putin presented demographic improvements as a key strategic priority and announce a 10-year programme to address them. The main idea is to encourage women to have a second child. The system of welfare/maternity subsidies/maternity capital (something new for Russia: mothers of a second child will receive RBL250000 (US$9260) and in three years time will be able to use this money to pay for education, mortgage, or put them into the accumulative part of their pensions) are planned to be very substantially increased. Although improvements in subsidies are not always efficient, this time they could help a lot, in particular in relatively poor regions. The finance minister preliminarily estimated additional budget expenditures at RBL40bn a year, which looks too optimistic. We expect that the actual growth in expenditures may be in times higher. In any case, the government should be ready to see new inflationary acceleration already in 2007 and develop anti-inflationary proposals.
Defence: Putin stressed that an arms race presents a threat to global security. He mentioned that although Russia spends some 2.7% of GDP on military expenditures (comparable to France and GB), it may not be sufficient as in absolute terms Russia spends less. He called to keep the arms and nuclear balance and said that this was a realistic target. Any way, we can expect new increases in military expenditures, in particular on new weapons and development.
Investment implications: We welcome the earlier liberalisation of capital account operations, which is positive for the local debt market. The demography programme has been very positively received, which is not surprising. Nevertheless, the government should be ready for new acceleration in inflation due to new budget expenditures in 2007.

Julia Tsepliaeva Moscow (7 495) 755 5489