During Invesco Fixed Income's Emerging Markets team's recent trip to Russia and Ukraine, we met with the management teams of 20 companies, as well as with analysts and economists of local investment banks. Overall, we left the meetings believing that de-escalation of the situation in Eastern Ukraine will continue.
With that, we expect spreads on Russian corporate bonds will continue to tighten on a relative basis, as the risk of "Level 3" sanctions continues to recede due to generally solid fundamentals, attractive relative value and supportive technicals.
Despite the fact that Ukrainian corporates continue to offer high yields, and despite our positive fundamental view of top-tier Ukrainian industrials, we remain cautious toward this segment of the market. We expect volatility to remain severe given the high level of political and economic uncertainty in Ukraine.
Moreover, the Ukraine banking system remains in a difficult position as banks continue to see deposit outflows and limited access to credit from international banks and investors. This is putting pressure on all but the top-tier Ukrainian corporates - at best, local banks are only willing to roll over existing financing, and access to capital outside of Ukraine is limited. The pressure facing Ukrainian corporates is further exacerbated by the weak Ukrainian economy.
The knock-on effect of Russia's involvement in Eastern Ukraine
Two questions were regularly voiced during our meetings in Russia: "Are western investors comfortable holding Russian corporate debt?" and "Is the market open to new Eurobond issuance by Russian companies?" We believe such questions indicate that management teams are highly sensitive to the increased risk premium foreign investors have assigned to Russian corporate debt, as well as the reduced access to western capital markets that has resulted.
Russian corporate and sovereign debt has rallied significantly since the peak of the Crimean crisis, however, there is still a meaningfully higher risk premium assigned to Russian fixed income. Spreads are still wider than pre-crisis levels, and they are significantly wider relative to other emerging markets such as Mexico and Brazil. This a real cost to many Russian companies that utilize western capital markets as a key source of funding. Over the next 12 months, we estimate total financing needs of Russian companies will exceed $100 billion. Therefore, an increase of just 25 to 50 basis points can result in a significant amount of money being diverted from companies and their equityholders to foreign lenders. We think this provides a strong incentive for the Russian government to continue to ease geopolitical tensions.
Thoughts on valuations
Considering the easing of geopolitical tensions in the region, the generally solid fundamental position of Russian companies and the supportive technicals in the EM corporate market, we expect the increased risk premium assigned to Russian corporate bonds to continue to erode. This leaves us positively biased toward Russian corporate credit.
Despite the high yields offered by Ukrainian corporate bonds, we remain cautious as Ukraine is in the midst of unprecedented change and the economy remains under significant pressure. All of this leaves a high level of uncertainty, which will continue to drive severe volatility in Ukrainian corporate bonds. We believe the top tier of Ukraine corporates will outperform the broader market over the next two to three years. However, expectations of near-term volatility leave us very cautious and biased to wait for better entry points.
The performance of an investment concentrated in issuers in either Russia or Ukraine is expected to be closely tied to conditions within those countries and to be more volatile than more geographically diversified investments.
An investment in emerging market countries carries greater risks compared to more developed economies.
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