Russian Fixed Income Daily
- Treasuries still vulnerable
- MosReg-6 finally noticed by buyers
- RZhD-6 - the cheapest paper on the Russian Railways curve...

FX and money market

Yesterday, the dollar strengthened somewhat in the first half of the day, and as a result, the rouble lost some five kopecks. However, this weakness was very short lived. With the euro appreciating above USD/EUR1.28 – currently it is trying to touch USD/EUR1.29 - the rouble strengthened again and broke through the psychologically important level of RBL/USD27. Today, we expect the rouble in the range RBL/USD26.92-26.97, and market sentiment on its further appreciation remains strong. Although the CBR and government expressed concerns for the first time on its quick appreciation (see our comments in the economic section), we do not expect any immediate reaction.
In the money market, the situation remains stable. Overnight rates are low at 1.5% (as they have been throughout this week) and we do not expect any turbulence.

Julia Tsepliaeva, Moscow (7 495) 755 5489


Rouble bond market

Thursday was a strong day for domestic bonds: fuelled by excess rouble liquidity and expectations of further rouble appreciation, rouble papers rose in price in all three market sectors on the background of solid trading activity, which was above its average level for recent weeks.
The spread of Russia’30 over US10Y is currently 105(-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 68(-4)bp (a new historical low, but wide in a medium-term perspective: our target for it is 50bp).

US Treasuries still vulnerable
US10Y managed to establish a new local yield top in intraday trading yesterday, having reached 5.175%. Traders were selling 10-year notes in a fear of possible further rate increases following the FOMC meeting decision the day before.
Later yesterday an auction was conducted for a new issue of 10-year notes, which showed good demand and was about 2.5 times oversubscribed. The new paper was allotted at an average yield of 5.14%, so the benchmark 10-year rate immediately relocated to this level, where it is now. Such yield gaps have happened at previous auctions, so there’s nothing surprising here: usually the yield more or less restores itself within a couple of trading days, and after that on-the-run and off-the-run securities continue trading more or less at the same level.
It should be stated explicitly that long-term US Treasuries currently appear to have larger downside than upside. The current position of US10Y is neutral given today’s Fed target rate (5%), as we don’t believe that the yield curve can be significantly inverted in the nearest future. Accordingly, since there exists a probability that the short-term rate will be raised to 5.25% on 29 June, there exists a probability that US10Y will have to shift upwards towards 5.35-5.5% level.

Secondary trading
Price changes of high grade rouble bonds: OFZ 46018 +24bp, OFZ 46020 +19bp, Moscow-39 +17bp, Moscow-44 +41bp, FSK UES-2 +1bp, Gazprom-4 +32bp, RZhD-6 +12bp.
Second-tier papers: MosReg-6 +41bp, CenTel-4 +14bp, Kopeika-2 -5bp, Magnit -10bp, Megafon-3 -4bp, UTK-4 +11bp, VolgaTel-3 +8bp, WBD-2 +13bp.
Finally, market participants have paid attention to the undervalued state of MosReg-6, which yesterday jumped up in price by 41bp. Now, the YTM of this paper is 7.49%, i.e. below 7.5%, above which we recommended accumulating MosReg-6. Due to this good performance we believe the position of the bond has now become more neutral, although some speculative upside is still present: the fair YTM of MosReg-6 is currently approximately 7.3%, so we recommend those who acquired the paper above 7.5% to keep the bond on position until our next target is reached. Moscow Region is rated BB/Ba3 by S&P/Moody’s.
Also 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 8% to maturity in five years, while its fair point in 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.
On the curve of Russian Railways, RZhD-6 is currently the most undervalued paper. This bond was yesterday trading at 7.36% to maturity in 4.5 years, but its fair YTM based on the credit spread of its neighbours RZhD-3 and RZhD-5 is most probably in the range of 7.2-7.25%. Russian Railways are rated BBB-/Baa2/BBB by S&P/Moody’s/Fitch.
Among somewhat shorter papers, 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 8.15% 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 positive based on the expectation of further spread compression between the OFZ curve and US Treasuries. The pending 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 further short-term capital gains due to excess rouble liquidity and the inflow of foreign funds in response to President Putin’s parliamentary address.

Dmitry Dudkin, Moscow (7 495) 755 5480


Economic commentary
Paris Club deal of 2006
The Paris Club creditors will consider Russia’s proposals in June
Yesterday, the Paris Club representatives confirmed that they had received Russia’s proposals concerning the almost-full pre-payment of its Paris Club debt. Previously, Russia had planned to pre-pay US$12.5bn in 2006 (not including its debt to Germany or any debt originating later than 1991), as the agreement between Russia and the Paris Club of May 2005 easily allowed Russia to offer the deal under the same conditions as the pre-payment at par of US$15bn in 2005. Later, however, Russia expressed an interest in pre-paying US$9.5bn to Germany, including the part which had been securitised into Aries (EUR5bn)).
According to comments from the Paris Clubs headquarters, the idea of extended pre-payment was met very positively, which may ease the negotiation process. Russia expects to reach an agreement before the G8 meeting in St. Petersburg which is scheduled for mid-July 2006.
We strongly believe that the extended pre-payment will be very beneficial for Russia as it will reduce the temptation to spend stabilisation fund resources domestically, help to optimise interest payments, and eliminate the non-tradable portion of sovereign foreign debt. Nevertheless, this part of the deal will only be possible if Russia offers Germany a premium, at least enough to cover Germany’s interest payments on Aries.
Any further foreign debt reduction would indirectly imply buybacks of tradable debt, although the government is unlikely to openly acknowledge this intention. In any case, according to the finance minister, Russia will not directly buy back Aries as makes no sense in the framework of Russian foreign debt reduction.
Investment implications: We welcome the idea of extended pre-payments of the Paris Club debt as this could help Russia to further reduce her foreign debt and avoid domestic spending of the Stabilisation fund. If the deal is successful (which is very likely), the probability of a further upgrade in Russia’s sovereign rating will increase. With the pre-payment, no Russian risk will be included into Aries.
Reserves up
Last week, reserves jumped by US$5.4bn (!) to US$231.1bn
International reserves gained an impressive USD5.4bn rising to USD231.1bn the week ending 5 May 2006 – after the more than impressive result of the previous week, when reserves jumped by USD8.6bn. In that week, the dollar continued sliding against other global currencies, which immediately formed negative sentiment for it in the Russian FX market. Exporters and speculators preferred to dramatically increase their dollar sales and the CBR had to absorb this money from the market to prevent stronger appreciation of the rouble. In addition, the CBR has been recalculating the dollar value of its euro-nominated reserves (some 25-30% of total reserves), which results in USD0.7-0.8bn increase in dollar terms for each 1 cent of euro appreciation.
Yesterday, the CBR announced that the rouble’s real effective exchange rate appreciated by 6.5% in January-April 2006. It expressed its concerns that such a rapid appreciation could negatively impact the competitiveness of domestically produced goods. Arkady Dvorkovich (head of the economic department of the President’s administration) stressed yesterday that the appreciation should not exceed the 2006-target of 10%. We have expected such concerns and strongly believe that the government and monetary authority cannot ignore interests of domestic producers. The CBR is very likely to continue its FX policy and keep the rouble stable relative to the trade-weighted basket, and consequently we expect reserve accumulation to continue in the coming weeks.
Investment implications: Reserves are very sizeable, which will help to protect the economy from any external shocks. Market sentiment regarding the dollar remains negative and appreciation pressure on the rouble is high. The CBR will continue to limit its appreciation. We forecast reserves to grow further and reach USD240bn by 2006-end.

Julia Tsepliaeva Moscow (7 495) 755 5489