In previous articles, I've written about my investment opinions on the sovereign debt of India, Sri Lanka, Indonesia, Colombia (position now closed), and Mexico (all toward the long side). I'm also effectively short the sovereign debt of Germany, Japan, and Italy (hedged with US Treasuries in the case of the latter). In this post, I intend to write about my position in Russian sovereign debt.
Russia has an inverted yield curve, which indicates that the market believes that Russia's economy is under near-term pressure and therefore credit risk is higher in the shorter-duration securities as opposed to the latter. The 3-year bonds reached a peak yield of 15.9% in December 2014 due to a combination of an economic decline abetted by a collapse in energy prices and geopolitical risk.
The Central Bank of Russia attempted to stem capital outflows by hiking rates by 650 basis points that month, simultaneously causing spikes in fixed-income yields. At the same time, Russian financial entities were largely closed off to international financial markets as part of sanctions related to political actions taken by the central government. The confluence of these related events produced three-year yields higher than the financial crisis-related peak of 15.3% in February 2009.
Since then, yields have come down to 8.5%. Those who got in a year ago at the bottom of the recession were still looking at 10%+ yields. In a world where bonds are the most expensive they've ever been as a whole, Russia remains an option for those willing to go the international sovereign bond route.
Russian debt should improve in the years ahead in conjunction with its strategy to reduce its reliance on natural resource exportation and in favor of a greater degree of economic diversification. Oil exports are expected to fall 1.5%-2.0% in 2017. Nonetheless, overall export volumes are projected to increase to somewhere around 2.0%-2.5% as a consequence of non-energy shipments.
Real GDP growth should come in around 1% for 2017, which would finally put an end to the ongoing recession, now seven quarters in length when measured on a year-over-year basis:
A return to positive real growth and conservative leverage metrics are both positive developments. Accordingly, Russia's ability to pay should remain robust and should support greater demand for its bonds going forward. The potential implementation of structural reforms represents one major catalyst that could boost Russian debt moving ahead, but the market has been waiting on this for several years, to no avail.
Fiscal consolidation efforts should decrease the federal deficit from 2%-3% of GDP to somewhere around the 1.5% mark in 2017. Revenue is expected at around 32%-32.5% of GDP with expenditures somewhere around 33.5%-34.0% of GDP.
Monetary policy is an additional tailwind to the bonds. The benchmark rate is currently set at 10.00%. Inflation's trek down to 5% and slow economic growth supports the notion that Russia will continue to loosen its monetary policy. This, in turn, should further push down bond yields.
Inflation is at five-year lows:
In the long-run, Russia's rates should dip back down below 6% as the economy picks up steam and inflation becomes more in line with other developed market economies. (Russia is still technically considered an "emerging market" but what counts as emerging and developed isn't a binary concept.) Rates were at 6% or below from 2010 through early-2014.
Aging demographics, low rates of immigration, and declining fertility rates also support the idea of lower rates over time. (Higher dependency ratios and diminishing consumption with age lower growth projections.) Russia is one of the older "emerging market" countries with an average age of approximately 40.
Major risks include sluggish forward growth prospects. Although the recession will likely be officially over in 2017, growth is unlikely to push beyond 1%-1.5% and will remain behind the US and Eurozone taken collectively. Geopolitical considerations and substandard institutions are regularly a thorny issue and naturally can't be separated from economics due to the risk of sanctioning by international governments.
Valuing Russian Debt
Below is an excerpt from a previous post on the general approach I take to valuing sovereign debt:
When it comes to equities and corporate bonds, I prefer to value on the basis of discounted cash flow. For sovereign debt, I prefer to value similarly to how the credit agencies assess risk - by looking at a composite of factors and bucketing into a generalized quality tier: median/mean real GDP growth, volatility in real GDP growth, GDP per capita, inflation, inflation volatility, government debt to GDP, government debt to revenue, interest expenses to GDP, interest expenses to revenue, fiscal deficit as a percentage of GDP, current account as a percentage of GDP, public debt to GDP, financial sector capital ratios, financial sector size as a percentage of GDP - roughly in that order - and more qualitative factors, such as the country's level of economic diversification, geopolitical risks, domestic political risks, corruption and quality of its rule of law.
Many of these ratios then bucket into a particular quality rating based on a predetermined range and an adjustable weighting factor system, are collectively assigned an overall rating. Through a database one can determine how often comparable scenarios defaulted in the past based on various time horizons - one-year, five-year, ten-year, etc. One should expect to calculate out an expected default rate until maturity.
From the expected default probability, we can then calculate out an appropriate discount rate that should represent the country-risk premium, equal to:
Country-risk premium = probability of default * (1 + 10-year Treasury) / (1 - probability of default)
The ten-year Treasury is used as a global risk-free rate. (Further theory behind this can be seen in a 1985 paper by Sebastian Edwards.)
Default probabilities on the Russian 3-years look to be around 3%-4%. Even if we used 4%, this would place the country-risk premium at around 4.3%, which is notably lower than the 8.5% actual yield. The implied country-risk premium according to the above formula would back out a figure of 7.6%-7.7%.
The 3-year is trading at around 960 currently in local currency. A country-risk premium of 4.3% would place the fair value of the bond at 1,065, for about a 10% undervaluation.
Compared to competing alternatives, the 8.5% yield here is relatively safe. I'm interested in mostly avoiding the US equities markets as I don't believe it's a much of a value-driven market at the moment. Foreign exchange risk can be mitigated by buying equal monetary amounts of bonds and the USD/RUB.
Anyone getting into Russian bonds or its equities market is a bit behind the curve (I was personally). Yields in the 3-years have decreased over 600 bps in the past two years. Russian equities (NYSEARCA:RBL) are up 56% in the past year based on the ETF highlighted in this sentence.
Three-years are trading around the 960 level with 6.8% coupons for an effective yield of 8.5%. With growth on the way up, planned fiscal consolidation, moderating inflation, and rates that are likely to decrease over the coming years, Russian debt has a few tailwinds in its favor. Even if the debt doesn't appreciate before its 2019 maturity, one would still lock in 8.5% unleveraged yield assuming no default if one were to hold it for the next 33-34 months, which isn't bad in today's world.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long 3-year Russian government bonds (ISIN: RU000A0JTG59)