Each week we screen thousands of corporate bond listings to find what we believe is currently the best corporate bond for investors needing or seeking higher yields with the least amount of risk possible relative to its projected return. This week, we look at high yielding 68 month from Federal Grid Company of Unified Energy System (FEES.ME), the operator and manager of Russia's unified electricity transmission grid system, including high voltage transmission lines, which gives it the status of a natural monopoly. Although this bond is rated Baa3 by Moody's and BBB by Standard & Poor's, on a LT National Scale S&P and Moody's have placed it at ruAAA and AAA.ru, respectively. In other words, it appears this bonds credit ratings are constrained by the Baa1/BBB sovereign ratings currently given to the country it operates within. The following review shows why we see the 8.5% yields currently indicated with this high quality short to medium term note is a savvy bet for fixed income investors to achieve both good cash flow and high yields. We also believe this debt instrument offers sound diversification away from the financial services sector of the global economy and from overweighted U.S. dollar-based assets. Therefore, we are adding it to our Foreign and Global Fixed Income Investments.
Wealth Preservation Concerns
Wealth preservation continues to be one of the biggest concerns among our clients. Fed chairman Bernanke this week stated that the Federal Reserve was failing on both of its core mandates, that inflation was too low and unemployment too high. While U.S. 10 Year yields have recently rebounded to over 2.5%, it was clearly communicated to us that the central bank was unlikely to scale back its stimulus measures earlier than expected and that a "highly accommodative monetary policy was needed for the foreseeable future." Moreover, Bernanke warned that "if financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that." The immediate response to this was a quick sell-off of the dollar and strengthening of the euro, and global stock markets are rallying.
Russia has undergone significant changes since the collapse of the Soviet Union, moving from a globally-isolated, centrally-planned economy to a more market-based and globally-integrated economy. The economy had averaged 7% growth since the 1998 Russian financial crisis, resulting in a doubling of real disposable incomes and the emergence of a middle class. However, it was one of the hardest hit by the 2008-09 global economic crisis as oil prices plummeted and the foreign credits that Russian banks and firms relied on dried up. The economic decline bottomed out in mid-2009 and the economy began to grow in the first quarter of 2010. Economic reforms in the 1990s privatized most industries, with notable exceptions in the energy and defense-related sectors. The Russian export industry consists primarily of natural gas to the eurozone, is the world's second largest exporter of oil, and is the third largest exporter of steel and primary aluminum. This reliance on commodity exports makes Russia vulnerable to boom and bust cycles following the highly volatile swings in global commodity prices, and provides reason for the higher correlation of its currency to oil prices. Growth for 2011 was 4.8% as oil prices continued to decline growth estimates for 2013 were slashed to 2.4% from 3.8%, which is well below the government's target of 5%.
While many economists are predicting further weakening, Russian stocks have dividend yields near 4% and PEs of only about 5x. Despite the currently high consumer price inflation (6.9%), there appear to be no signs of heating in prices and the CPI drivers point to easing inflation. This in turn could lead to the Russian central bank lowering key rates. Although Russia is home to 11 of the world's top 100 billionaires, the government insists that austerity measures are the only solution to Russia's faltering economy. Last month, Russian President Vladimir Putin warned of the coming austerity program, insisting in his annual presentation of the proposed budget for 2014-2016 that the country's slowing growth meant that the state could no longer increase spending. Russia's competitive flat income tax rate and low corporate tax rates support innovation, although private enterprises also must cope with "informal taxes" such as bureaucratic hassling and corruption. While President Putin continues to hold on to the economic system he created known as state capitalism, he has started a program aimed at improving Russia's rank in World Bank's Doing Business survey by 100 steps. What improvements this might result in uncertain, and despite repeated policy declarations that Russia is moving towards diversifying its economy, the country's wealth and state budget remain overwhelmingly dependent on income earned from the energy sector.
In the first quarter of 2013, oil provided nearly 50 percent of total budget revenues. What we are noticing is that oil prices have recently begun to rise again, as the geo-political premium which had disappeared appears to be coming back. Should this trend continue, we see it a positive for both the Russian economy and its currency.
A look at the issuer
Federal Grid Company was incorporated in June 2002 as part of the reorganization of Russia's electrical power industry. The largest shareholder, with a 79.55% stake, is a holding company of the Russian Federation Government formally named "Russsian Grids". Federal Grid's business is to provide electricity transmission and technological connection services. It maintains and develops the grid system and supervises grid facilities and infrastructure in 74 Russian regions, covering a territory of 13.6 million square kilometers. Its customers are regional distribution companies, electricity suppliers and large industrial enterprises. The company's assets include more than 131,6 km of transmission lines and 891 substations with more than 335 GVA of 35-750 volt transformer capacity. Based on the length of transmission lines and installed transformer capacity, Federal Grid is the largest publicly traded electricity transmission company in the world. Not only does it enjoy the enviable position as a natural monopoly within its market area, it is difficult for us to conceive of a more essential industry to the economy of an industrialized nation.
Russian capital markets are relatively small but growing and are dominated by energy companies. Federal Grid employs more than 25,000 people, and its ordinary shares are listed on the Moscow Exchange under the ticker symbol FEES and the Company's GDRs are traded on the London Stock Exchange under the same FEES ticker symbol. The Company's shares are included in the MSCI Emerging Markets and MSCI Russia indices.
The largest part of Federal Grid Company revenues is generated via tariffs for electricity transmission, approved by the Russian Federal Tariff Services based on RAB-regulation. It has demonstrated its solid growth in capacity, revenues and earnings, as indicated in the tables below:
Key Production Indicators
Number of substations*
Transformer capacity (MVA)*
Total transmission grid length, thousand km*
Electricity transmitted from UNEG to distribution grid companies, direct private consumers on the wholesale energy market and independent AO-Energos (million kWh)
Electricity transmitted from UNEG to neighboring countries (million kW)
Total actual electricity losses (million kWh)
Committed capacity (MW)
Key financial indicators (IFRS), RUB million
Adjusted operating profit***
Adjusted profit for the period****
Federal Tariff Service approved tariffs under RAB regs for 2012 - 2014:
Return on initial invested capital
Return on new invested capital
The new tariff regulation fosters conditions to attract capital for the development and support of the Company's assets, as well as provides a financial incentive to improve the quality of customer service and efficiency of operations. RAB regulation directly correlates profits with the reliability of the electricity supply and the level of customer service. Federal Grid's fundamental importance to the Russian economy puts reliability and stability in the transmission of electricity throughout the country as its main strategic priority, and some of the Company's key development goals are to expand and upgrade the power grid to internationally accepted standards, and to reduce the rate at which fixed assets wear out and are retired. Federal Grid signed Strategic Cooperation Agreements with Siemens AG (SI) in its implementation of new Siemens technologies such as low-loss high-voltage DC transmission (HVDC) or smart grids on FGC objects. Production of electro technical Siemens' equipment in Russia and service and reconstruction of installed Siemens equipment on power facilities of FGC were also part of the agreement. Siemens will also be supplying high-voltage equipment for the Olympic Games to be held in Sochi in 2014. Furthermore, in the world's largest line protection project of its kind, Siemens supplied 639 line-based high-voltage arresters at the 500 kV voltage level for protection of the Russian power transmission lines. Last October the Russian Ministry of Energy adopted the company's 2013-2017 investment program, which amounts to over 775.5 billion rubles, and last month (June) Japanese technology giant Hitachi (OTCPK:HTHIY) entered the Russian energy market after signing a scientific and technological cooperation agreement with Russian Grids (79% owner of Federal Grid) to provide technical cooperation on the modernization and stabilization of power distribution infrastructure.
Federal Grid's immense size and the fact that the company is a monopoly in the market gives it considerable advantages, including: financial stability, steady growth and the possibility to efficiently manage risks. What stands out to us here is that the company is striving to comply with the best international practices in this sphere, is using its strengths to upgrade operating efficiency, and is achieving a profit level necessary to finance its investment program.
Interest Coverage Ratios
Federal Grid's adjusted EBITDA for 2012 was 82.1 Bn rubles ($2.54 billion dollars), and the adjusted EBITDA margin was 58.5%. While the high 153.3 Bn ($4.74 billion dollars) Capital expenditures of its investment program resulted in a 95 Bn increase, to 168.0 Bn ($5.2 billion), of its net debt position, interest for the year appears to be about 11.7 Bn ($362 million), indicating a interest coverage ratio greater than 7 to 1. Dividends of 2.54 Bn rubles ($78.6 million) were paid to its equity holders as a result of a recently implement dividend policy.
We like higher yields
Federal Grid has various debt issuances denominated in rubles with coupon rates ranging from 7.15% to 9% and maturities between Oct. 2015 and Oct. 2027. We are targeting the 8.446% bond maturing in March of 2019, which may have better liquidity and appears to be trading at or slightly below par.
The default risk is Federal Grid's ability to perform. Considering its vital importance to the Russian economy, its monopolistic status, and its outstanding credit ratings, as outlined above, it is our opinion that the default risk for this medium term bond is extremely low compared to other risks and its favorable return potential.
A harder risk for us to identify is the geopolitical risk. Since we find it hard to understand many of the political changes even in our own country, perhaps the uncertainties of changes on a foreign soil become less formidable. With that said, it is our opinion that diversification into other forms often serves to reduce risk. Our strategy here, as with other global bonds, is to focus on unique or required services that can be seen as adding key economic value to the society it's associated with.
The currency risk of the Russian ruble could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to the Russian economy. The Russian Federation displays certain characteristics of an emerging market that typically include relatively higher inflation and higher interest rates. The future economic direction of the Russian Federation is largely dependent upon the effectiveness of economic, financial and monetary measures undertaken by the Russian government, together with tax, legal, regulatory and political developments. While higher oil prices are likely to help Russia reduce the budget deficit inherited from the lean years of 2008-09, lower oil prices would impede progress in this area.
We believe that these Federal Grid bonds have similar risks and maturities to other Russian ruble currency bonds such as the 9.1% RusHydo (OTCQX:RSHYY) bonds, the 5.5% Caterpillar (NYSE:CAT) bonds, or the 9.43% Morgan Stanley (NYSE:MS) bonds, which we have reviewed previously on our Bond-Yields.com blog.
Summary and Conclusion
It is our opinion that Federal Grid is well positioned for the future as the sole operator and manager of Russia's unified electricity transmission grid system. It has an extensive, but sound, capital expenditure and growth program, excellent earnings and interest expense coverage, and undeniably vital importance to the Russian economy. As a result, we believe these Federal Grid bonds offer good diversification away from overweighted U.S. assets, as well as a very attractive yield relative to its maturity and the financial risks that we can identify, and have therefore chosen them for addition to our Foreign and World Fixed Income holdings.
Issuer: Federal Grid Company
Yield to Maturity: ~8.5%
Disclosure: Durig Capital and certain clients may have positions in Federal Grid's 2019 bonds. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.