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Amid Agency Rating Gloom, Russia Bonds May Be a Buy


The agencies announced a "negative outlook" for Russia's credit, but it's actually unlikely that the country will stop paying its bills.

You may not like Vladimir Putin or his policy in Ukraine. You may think, as I do, that his neo-imperialist adventures will significantly damage the Russian economy. But the idea that the Russian state will welsh on its debts still seems fanciful at this point.

Yet bond investors have marked down Russian sovereign paper substantially since the Ukrainian crisis went global a month ago, and may discount it further after two ratings agencies, Standard & Poor's and Fitch, slapped "negative outlooks" on the country's credit late last week. That could provide a buying opportunity for those who are not squeamish about financing Kremlin, Inc.

Really the Kremlin hardly needs investors' money, which is exactly the point here. Russia's corruption- and red-tape clogged economy is woefully inefficient, with labor productivity at about 40% of US levels, but its government is a fiscal powerhouse. Public debt comes to a mere 8% of gross domestic product, according to the CIA World Factbook, compared with 72% for the USA. Russia's budget, usually in surplus, ran a whole 0.5%-of-GDP deficit last year, against 4% for Washington. Their trade surplus came to 6.6% of output in 2013, our deficit was about 3%. And so on.

Russia's entire interest and principal payments on its sovereign debt this year are less than $9 billion, about 1/20th of its savings in two national reserve funds. When the finance ministry did not like the way interest rates were looking for a domestic bond sale Mar. 14, they just canceled it. They really only have the bond market to give local banks and pension funds a safe-haven instrument anyway.

Putin and the rest of the Russian elite were also emotionally scarred by the country's debt default in 1998 and the years of humiliating talks with creditors that followed. It has been a centerpiece of their policy never to let Russia be so vulnerable again. So why is such a country threatened with a downgrade of a credit rating that is not so hot to begin with -- BBB, or two notches above junk, from S&P?

First it should be noted that emerging-market nations issue two kinds of bonds, which are often confused in commentary but driven by different fundamentals: obligations in their own currency and in foreign currency. The latter are known as Eurobonds, though in fact they are usually denominated in dollars. International investors buying local bonds are largely betting on the currency in question and underlying factors affecting it like inflation.

Russia's local bonds have been hammered by its involvement in Ukraine, yields on the 10-year benchmark jumping from 8% to 9.5% since President Viktor Yanukovych fled Kiev in late February. That is a bigger yield than some Fragile Five countries like India and Indonesia pay, but it could be justified given a swoon in the ruble that could well continue given the huge volume of money fleeing Russia as financial conflict with the West intensifies. Russia's own economics ministry put capital flight at $35 billion for January and February, compared to $65 billion for all of 2013.

Eurobonds, which are the more common instrument for global investors, are another story. These should be a pure-play bet on the issuing nation's likelihood of default, which for Russia would have to be considered slim. Yet Moscow's hard-currency debt has also sold off sharply. Its benchmark Eurobond, which matures in 2030, now yields 6.4% according to Frankfurt Stock Exchange data. That is comparable to the bonds of Greece or Iceland, countries struggling to recover from calamitous bankruptcies, and much wider than the local-currency debt of Hungary or Thailand, hardly bastions of financial stability.

If something is wrong with this picture, it would not be the first time the global rating agencies have miscalculated sovereign credit risk. S&P and its rivals seem to work well enough analyzing corporate balance sheets, but our industrious colleagues at Bloomberg found that the market confounded half of S&P's downgrades of sovereign debt going back to the 1970s. That is to say confidence went up and yields dropped afterward. The most famous case was the agency's downgrading of US bonds after the Washington debt ceiling contretemps in Aug. 2011.  T-bills went on to record low yields soon afterward.

In fact neither S&P nor Finch has downgraded Russia. They issued "negative outlooks," which technically means the credit might be downgraded within the next two years. But investors in a mood to dump all things Russian might well overlook this distinction and overshoot with Eurobonds on the down side. 

To justify their credit warning, Standard & Poor's analysts wrote: "Geopolitical reaction to Russia's incorporation of Crimea could further reduce the flow of potential investment and negatively affect already weak economic growth." True enough, but that doesn't mean the Kremlin will stop paying its bills.
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