Russian Fixed Income Daily
- Opportunity in GPB-1 eliminated
- RSHBank-2 still cheap
- Baltika attractive above 7.5% YTM...

FX and money market

Last week, driven by euro/dollar turbulence, inter-day fluctuations of the rouble in the Russian FX market were high (up to ten kopecks) and it finished the week at RBL/USD27.03 (minus five kopecks over the period). This morning the dollar is continuing its appreciation that started on Friday, and is currently trading at USD/EUR1.274, pushing the rouble to RBL/USD27.06. Today we expect a very calm day due to holidays in both the US and UK, although the rest of the week is expected to be tense on the back of coming macroeconomic releases, with the most important being Wednesday’s Minutes of the 10 May FOMC Meeting and Friday’s change in non-farm Payrolls, which may give the market some clue of further developments in US monetary policy. Today we see the rouble in the range of RBL/USD27.04–27.09.
In the money market, despite the tax payment period and end-of-month effect, interbank overnight interest rates were around 2.5–3% on average most part of the week and notable liquidity tightening (interest rate spiked to 6%) was seen on tax payment days. Today profit tax is due, so some deterioration of money market conditions is possible. In addition, given last Tuesday’s massive dollar sales, the market is full of rouble funds (NOSTRO balance have exceeded RBL400bn) so we expect the market will manage these payments without any significant problems.

Olga Golub, Moscow (7 495) 755 5176


Rouble bond market

Friday was a strong day in all three market sectors: fuelled by a rally in Russian stocks, long rouble bonds also enjoyed the attention of buyers, which led to price increases in the range of 10–20bp. On the other hand, trading activity was below average, implying that this movement was not seen by participants as the beginning of a larger growth.
The spread of Russia’30 over US10Y is currently 120(-2)bp (very wide, with a compression potential of 30bp from an historical standpoint), while the spread of OFZ 46018 over Russia’30 is 57(+3)bp (wide in a medium-term perspective, our target for the spread is 0bp).

This week’s highlights
Today, US10Y is at 5.05% and is unlikely to change its position due to the holidays in both the US and UK. We have many times mentioned that we don’t believe the benchmark rate will be able to remain below 5% for a long time. As a result, the current position is only neutral if the Fed target rate remains unchanged at the next FOMC meeting on 20 June, and is too low in yield if the Fed raises its rate again to the 5.25% level. Meanwhile, another rate hike is still very possible: July Fed funds futures are now at 5.14%, i.e. almost in the middle between the two probable outcomes. Bloomberg economists’ survey gives an average rate of 5.1% – slightly more conservative, but still very close to the middle of the range. Therefore, the question about the next FOMC decision remains unsettled for the investment public. The key data release that might help shift the balance to one side or the other is the publication of the minutes of the 10 May FOMC meeting on 31 May, i.e. this Wednesday. Overall, our view is that US Treasuries are currently low in yield and have a higher probability of reaching 5.2% than shifting below 5% by the end of the week.
On the other hand, the situation on the money market will be improving. In spite of the ongoing tax payments, the overnight rate is currently at 2.75%, which is rather modest and promises further improvement in the first days of June. The natural accumulation of rouble funds at the beginning of next month will cause a fall of money market rates to their lows fostering demand for long rouble bonds.

Secondary trading
Price changes of high-grade rouble bonds: OFZ 46018 +15bp, OFZ 46020 +28bp, Moscow-39 +2bp, Moscow-44 +22bp, FSK UES-2 +9bp, Gazprom-4 +15bp, RZhD-6 +14bp.
Second-tier papers: MosReg-6 +27bp, CenTel-4 +20bp, RusAl-3 -5bp, RSB-4 +13bp, RSHBank-2 +23bp, TMK-3 +4bp.
The buying opportunity in GBP-1 we mentioned in our previous update has essentially disappeared: the cheapness of the bond of Gazpromabank was spotted not only by us, but apparently by many others, and as a result, GBP-1 jumped up in price 55bp on Friday driving its YTM (in five years) lower to the 7.75% area. At this point the bond appears to be fairly valued, at least in the short-term perspective. Gazprombank is rated BB/Baa2 by S&P/Moody’s.
On the other hand, RSHBank-2, a bond of Rosselkozbank – a quasi-sovereign entity created by the Russian government to finance the agricultural sector, remains undervalued in our opinion. On Friday the paper was as usual located at 8% to maturity in five years promising a significant price upside. In the longer term, the fair value of the bond is in the range of 7.5–7.75%, so even in adverse market conditions, RSHBank-2 should behave quite well. Rosselkhozbank is rated Baa2/BBB by Moody’s/Fitch.
TMK-3 – a bond of the Tube Metallurgical Company (TMK) – has been recently moving up and is now located at 8.1% YTP for 21 months. Above 8% the paper definitely retains speculative upside as we believe that its fair value in current market conditions is in the range of 7.75–8%.
RusAl-3 was lately around 7.75% YTM for 29 months, while 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. The company recently announced it was planning to borrow as much as USD1.5bn from a syndicate of Western banks in tranches of 5–7 years, but as the new funds will be used to refinance existing debt this should not cause a significant debt burden increase.
MosReg-6, a bond of the Moscow region that we previously recommended for buying, rose 25bp on Friday and is now trading at 7.45% to maturity in five years. We continue to estimate the fair YTM of MosReg-6 at 7.25%, which makes this paper one of the most undervalued long rouble bonds. Moscow region is rated BB/Ba3 by S&P/Moody’s.
Impex-3, a bond of Impexbank recently acquired by Raiffeisen, was quoted at about 8.1% to put in 12 months. Due to the acquisition, the bank has been upgraded by Fitch and Moody’s to investment grade rating BBB-/Baa2, so now it continues to be above its fair yield, which is located somewhere in the range of 7–7.5%. We definitely recommend accumulating Impex-3 for passively managed portfolios.
Also regarding the short papers, Baltika was recently traded at about 7.9% to maturity in 18 months, which is definitely too high for this high-quality paper. Its fair value is probably 7.25%, but lack of liquidity prevents the paper from moving there. Therefore, if Baltika can be found above 7.5%, it’s a candidate for buying.

Market view
In the long-term perspective, the rouble bond market retains significant attractiveness relative to dollar Eurobonds due to the expected further appreciation of the rouble and the removal of capital controls on 1 July.
Specifically, we believe that the spread between OFZ 46018 and Russia’30 could shrink to zero by the end of 2006, while in addition, the spread between Russia’30 and US10Y is currently extremely wide and does not incorporate the further expected Paris club debt prepayment. As a result, these two wide spreads create a good safety cushion for the rouble market, which should drive the yields of rouble bonds down – or at least leave them intact in case of a sharp fall of US Treasuries.
In the nearest future, the local market will find itself between the potentially falling US10Y, which are now possibly too low in yield, and excess rouble liquidity at the beginning of June, so for the moment our recommendation for long rouble bonds remains a Hold.

Dmitry Dudkin, Moscow (7 495) 755 5480


New window for international business cooperation
Russian steel company Severstal merges with Arcelor, which will become the new positive example of a successful merger after the TNK-BP deal
Last week, two steel giants – the Russian Severstal and global Arcelor – signed an agreement for their merger. This is a very important deal not only for the equity market as its macroeconomic and political implications for Russia are far reaching. First of all, the deal is very big (USD13bn), and secondly, Russian oligarch Alexei Mordashov has won control of over 32.2% of the new company. The deal is good for Arcelor, which is a public company, as it helps to protect it from unfriendly merge with Mittal group, while Severstal with Alexei Mordashov is much more loyal investor. On the other hand, Alexei Mordashov won the merger deal with one of the world’s steel giants, which is not typical for Russia. Previously, there has been only one similar case – TNK-BP deal, after which the Kremlin became opposed to such ideas in general. A tendency of the government’s strengthening control over economic activity in the so-called strategic sectors (a list of strategically important sectors has not been determined, which has resulted in all big businesses possibly being considered as strategically important) has become dominant. Nevertheless, Alexei Mordashov – one of the most loyal big businessmen to the Kremlin – managed to persuade the Russian authorities that the deal will strengthen their reputation and improve Russia’s image in general. Indeed, with the deal, Russia will be able to show a second positive example of an international merger, which could play a role of a second policy window display for of President Putin’s administration regarding relationship with big business and international mergers. Nevertheless, the Severstal-Arcelor deal is unlikely to begin a new trend although some experts believe that the deal might be considered as a signal of a more liberal position of the Kremlin. In any case, the “rules of the game” are not transparent at all, which make some one-off deals possible while strengthening control over oligarch-controlled business as a mainstream policy.
Investment implications: The deal between steel companies Severstal and Arcelor has positively impacted the Russian equity market. It is also important from a political point of view: the Kremlin now has a second positive example 9after TNK-BP of a successful merger between a Russian and a foreign company. Nevertheless, we do not expect similar deals to become popular in Russia, as the main tendency remains the same, with the Kremlin strengthening its control over business. Consequently, we do not expect any slow down in the flow of IPOs.

Julia Tsepliaeva, Moscow (7 495) 755 5489