Russian banks had little direct exposure to US sub-prime mortgages but the impact of the sub-prime mortgage crisis has nonetheless affected the ability of Russian corporates and banks to raise funds in the international capital markets. Michael Pugh and Jonathan Russell of Lovells report.
When the credit crunch started to bite, Russian direct exposure to US MBS and MBS-related products was limited. According to figures derived by Wachovia’s Economics Group from the US Treasury’s benchmark survey of foreign holdings of US securities, as at 30 June 2006 Russia had about US$50bn’s worth of exposure to the US mortgage market in total (for comparison, China had over US$250bn’s worth of exposure, the UK approximately US$70bn). The bulk of Russia’s exposure, however, resulted from the ownership of securities issued by government-sponsored entities, such as Fannie Mae and Freddie Mac, to finance mortgage purchases. In other words, Russia was not exposed to securitised products or the US mortgage market directly, and what exposure it did have to the US mortgage market was implicitly backed by the US government. We are not aware of any change in this trend in 2007.
Notwithstanding Russia’s limited exposure to US sub-prime credits and derivatives, Russian issuers have felt the impact of the credit crunch, which has resulted in a dramatic drop in demand for Russian foreign currency bonds and share offerings alike. The reduction in distribution in the debt and equity markets has presented Russian issuers with funding challenges. Although smaller Russian issuers were initially the hardest hit, it is now clear that even top-rated Russian issuers have only been able to access the markets at notably higher prices. The syndicated loan market faces heavy demand from borrowers forced to look outside the international capital markets. The volume of syndicated Russian credits, which had totalled US$48bn and US$40bn in 2005 and 2006 respectively, exceeded US$86bn in 2007, and 2008 looks set to be similarly busy. Domestic bonds also appear set to play an increasing role in the financing of both corporates and financial institutions.
The performance of the Russian capital markets in the first half of 2007 was strong. New issuances of Eurobonds reached US$27.2bn in the six months ended 30 June 2007, outstripping the total volume of issuances in 2006 (US$24bn). Domestic bond issuances, which had reached record figures of over Rbs180bn (US$7.7bn) in the last quarter of 2006, continued to be strong, with over Rbs131bn (US$5.8bn) issued in the first quarter of 2007, and a new record of Rbs205bn (US$8.7bn) in the second. The Russian securitisation market was growing exponentially following Gazprom's 2004 US$1.25bn structured export note issue and Russia’s first true-sale asset-backed securitisation in July 2005 by Bank Soyuz, with volume approaching US$3.5bn in 2006. Equity markets were equally buoyant. In the first half of 2007, Russian equity issuance reached US$23.3bn, which exceeded the volume for the whole of 2006, and gave Russia the second highest volume of issuances in Europe after the UK, with 15% of total European issuance over the period.
Despite increasing turbulence elsewhere in financial markets at the start of the third quarter of 2007, bankers were still able to find distribution for Russian credits. Kuzbassrazrezugol, LOCKO-Bank and Probusinessbank were among the issuers to take advantage of this in July 2007, while Rosselkhozbank (RAB) agreed Russia’s first ever upper tier two financing, a US$200m bilateral loan from ABN AMRO that was structured as a 10 year no-call five.
There were hints, however, at difficulties to come, for while there was no shortage of new mandates and an increasing appetite among Russian banks and corporates to issue, bankers were faced with a shrinking distribution pool, which either meant that pricing rocketed, or that there was no distribution available at all. The striking example was Rosneft, which postponed its debut Eurobond on pricing grounds. August is usually a quiet month in Russia (except where coups are concerned), but the market failed to bounce back in September. The only significant offering was Gazprom’s US$1.25bn 30-year Reg S/Rule 114A LPN issue in early August 2007, an issue whose pricing at 225-230bp over Treasuries emphasised the difficulties facing other issuers, and the fact that the market was increasingly closed to all but the most solid blue chips or quasi-sovereign entities. By the first week of October 2007, 17 domestic issues worth a total of Rbs40bn and 12 Eurobond issues worth a total of US$4.95bn had been postponed.
By the beginning of the fourth quarter of 2007, the effects of the credit crunch were clearly felt in Russia. On 1 October 2007, the overnight Moscow interbank offered rate, which had remained steadily below 5% between the end of March 2007 and mid-August 2007, reached a two-year high of 9.17%. Private banks were especially hard hit: the one year CDS on Russian Standard Bank, for example, surged above 700bp in late September. Even state-backed banks were not immune, the price of a five-year CDS for Bank VTB increasing by 30bp against the lower rated Gazprom despite having kept parity throughout the summer. Certain large blue-chips were able to re-enter the debt market in October 2007: TNK-BP was the first, issuing US$1.7bn of 10- and five-year notes, while Gazprom returned to make a EUR1.2 billion 10-year Reg S issue. Priced at 187-193bp over Treasuries, the book was oversubscribed by almost EUR7bn. Bank VTB made the first CIS bank issuance since 19 July 2007 when it issued a US$2bn dual tranche Reg S/144A Eurobond, with five-year fixed-rate notes with a 6.609% coupon and 2-year FRNs paying 170bp over LIBOR. All three issues were distinguished by the generosity of premium offered, however, and any anticipation of a general market recovery was premature as distribution failed to recover more widely in November and December 2007. The strengthening of the secondary debt market also reduced demand for new issuances.
The effect of the credit crunch on securitisations was pronounced. Issuance volume had reached over US$1.9bn for the eight month period ended August 2007 (7 deals), but quickly stalled thereafter. In contrast to the US, however, this reduction was not caused by any drop in the quality of the credit offered, but rather by the drop in demand for securitised notes.
In equities, meanwhile, the RTS had performed indifferently throughout the first half of 2007, partly perhaps because of the performance of gas and oil stocks (which comprise about half of the market), but also partly because of a glut in supply. Many IPOs, such as that of property company AFI Development, lost considerable value in their first few months of trading, and some are yet to recover (at the time of writing, AFI was trading at just over US$8 per GDR, down from its issue price of US$14). In the third quarter of 2007, Russian companies offered a mere US$529m of shares, compared to the US$10.8bn in the same period in 2006, or US$15.6bn in the second quarter of 2007.
Difficulties in raising debt and equity funding, however, have not diminished Russian companies’ funding needs. The Russian economy continues to grow rapidly, with growth reaching 8.1% in 2007. It is this healthy growth which ought to guide any view of the risk in the Russian capital markets.
The syndicated loan market has played a key role in satisfying demand. Traditionally dominated by commodity and energy companies, it had already expanded by mid-2007. As the credit crunch reduced the availability of capital markets funding in Russia, the syndicated loan market showed itself to be a willing substitute. Pricing had grown tight in the first half of 2007, leaving liquidity in the corporate loan market increasingly dependant on a small number of top-level arrangers, who were now increasingly conscious of their own capital restraints. With such lenders requiring increased returns, and an overall increase in demand, pricing widened. Demand nonetheless continued to increase and by the end of the year there was estimated to be a US$35bn pipeline of loans ready for syndication in the first quarter of 2008.
While the loan market has provided one alternative financing source for Russia’s banks, Russia’s domestic bonds market has also proved to be a fruitful source for financial institutions. Domestic Russian bond issuance fell in the third quarter of 2007, but on a longer-term view the Rbs70bn issued was not an especially low figure, and in the fourth quarter domestic issuance rebounded to over Rbs110bn, almost 75% of which was issued by financial institutions. The absence of other industry sectors suggests smaller issuers were pulling back from a tight market, but also emphasises the importance of domestic bonds to Russian banks. Despite the credit crunch, a strong rouble and a burgeoning local investor base made this market a key prop for the sector. 2008 has seen corporates return to the domestic market following TGK-10’s Rbs5bn issue in February 2008, and distribution is there at the right price. Outstanding rouble bonds, according to Dresdner Kleinwort estimates, now almost equal outstanding Eurobonds, and are widely expected to overtake them in 2008. The appreciation of the rouble has contributed to this trend.
Going forward, both domestic bonds and the syndicated loan market are likely to play significant roles in satisfying the funding needs of Russian corporates and banks. The international capital markets, however, should not be written off.
So far 2008 has been quiet for Eurobonds – Bank of Moscow’s SFr50m tap of its existing March 2011 LPNs was the only public deal up to March. But a large number of larger corporates and banks intend to re-enter the market in the second and third quarters.
International buyers can also be found for securitisations. Eurocommerz recently closed a Rbs8bn private deal which was the first Russian securitisation of factoring receivables, a deal noteworthy for its distribution method, with Deutsche Bank selling it on in various formats (including CDS, total return swaps and a sub-participation trade) to a traditional emerging market investor base. Private placements also offer an alternative strategy for vanilla Eurobonds, including those issued by mid-rated issuers. Even in late 2007, for example, Sudostroitelny Bank was able to place US$50m 10-year LPNs (with a 12% coupon).
As outstanding bonds mature, issuers will need to tap all available sources of funding. Disclosure must be up-to-date and for most issuers, this means updating their offering documentation to reflect their 2007 IFRS financial statements and keeping investors updated. Issuers should also consider borrowing backed by receivables and convertible bonds. Diversity of funding sources may help issuers to flatten maturity spikes. Widening the distribution base (to include private banks and the Middle East where liquidity is high) is also beneficial. Market openings may well be brief in the near future, and those issuers who are ready to enter the market at short notice look set to seize the day. As the saying goes: he who knows the road doesn't stumble.