Hedge Funds Foment Russia Credit Crunch With 16% Puts

Date: Wednesday, May 28, 2008
Author: Denis Maternovsky

A relic from Russia's debt default a decade ago is threatening the country's economic resurgence by forcing more than 200 companies to increase the interest they pay to as much as 16 percent.

With bond yields rising worldwide as the U.S. subprime turmoil spreads, hedge funds and other investors in Russia are demanding the higher rates or their money back.

Investors who were lured back to Russia with put options giving them the right to redeem debt forced Khanty-Mansiysk-based auto-leasing firm Ugra Leasing Co. in April to raise the yield on 1 billion rubles ($42.4 million) of three-year notes sold last year to 16 percent from 14 percent, according to data compiled by Bloomberg. Moscow-based supermarket chain Mosmart increased the coupon on 2 billion rubles of bonds from 11 percent to 15.5 percent.

``There will be some wake-up calls,'' said Ian McCall, a director at Argo Capital Management in London, which oversees about $1 billion of emerging-market debt.

The hedge fund rejected an offer from Moscow-based retailer Samokhval last month to increase interest to 14.5 percent from 11.4 percent, choosing instead to redeem bonds due in 2009, said McCall. ``It should have been even higher,'' he said.

Even with record oil prices pumping the economy, the global credit crunch is penalizing Russian borrowers as the put options leave companies liable for refinancing nearly a third of their 1.5 trillion rubles of bonds at higher rates by yearend, Bloomberg data show. Soaring interest costs may contribute to a slowdown in economic growth to 6.5 percent from 8.1 percent in 2007, said Ivailo Vesselinov, senior economist at Dresdner Kleinwort in London.

Money Back

Put options give bondholders the right to demand payment at face value on a set date. They became more common in Russia than anywhere else, according to Dresdner, after the government's $40 billion default in 1998 led to almost $4 billion of losses for Greenwich, Connecticut-based Long-Term Capital Management.

Investors rarely exercised the puts until last year because the interest they received was higher than what they could get on new bonds. The oil-led economic boom drove down the average corporate yield to 7 percent from 12 percent between 2004 and the middle of last year, according to ING Groep NV.

Even the country's biggest financial institutions have not been immune from put pressure.

Alfa Bank

Alfa Bank, the biggest private lender, had to raise the annual rate on 2 billion rubles of bonds due in 2010 by 3.6 percentage points to 9.5 percent last month to prevent holders from using puts to redeem the debt, according to Bloomberg data. State-owned VTB Group, Russia's second-largest bank, lifted interest on 15 billion rubles of notes maturing 2013 to 8.6 percent from 5.9 percent last month.

Average borrowing costs jumped 2 percentage points this year, said Pavel Pikulev, fixed-income analyst at Trust Investment Bank in Moscow. ``Investors are using the put options because they expect the coupon to be raised in line with the market rates,'' he said.

French investors became the first Russian default victims when the Bolshevik government refused in 1918 to repay tsarist debts. Eighty years later, Boris Yeltsin triggered a worldwide slump in financial markets after the country defaulted on ruble- denominated debt and devalued the currency more than threefold against the dollar. The moves forced the Federal Reserve to organize a rescue of Long-Term Capital.

Soaring oil prices helped Russia win back investors as the government built up the world's third-largest pool of foreign- currency reserves at $540 billion. Companies followed with 518 billion rubles of bond sales in 2006 and a record 520 billion rubles last year, according to Bloomberg data.

Improving Confidence

As investor confidence improved, companies began selling bonds lacking put options. Citigroup Inc. arranged a sale of 3 billion rubles of 10.05 percent five-year debt without the feature for regional lender Ursa Bank in 2006. Since then, worsening credit conditions meant that Russia's 17th-largest lender by assets last month had to offer a one-year put in a sale of 10 billion rubles of seven-year notes yielding 11.19 percent, Bloomberg data show.

Ruble bond sales slowed 15 percent in the first quarter to 111 billion rubles as hedge funds and others reduced holdings of riskier assets worldwide, Bloomberg data show. The ruble strengthened today to 23.6193 per dollar, compared with 25.8889 per dollar a year earlier.

``We are back to 2004,'' when Russian corporate debt sales surpassed 100 billion rubles for the first time, said Nikita Gusakov, head of ruble bond origination at Citigroup in Moscow. ``Appetite for risky investment has fallen and companies are once again luring investors by high yields and put options.''

Outside Russia

Companies outside of Russia have also started offering put options. Frankfurt-based Deutsche Bank AG, Germany's biggest lender, and Alpha Bank SA, based in Athens, were among sellers of $5.4 billion of puttable bonds this year, compared with $2 billion for 2007, according to London-based data provider mtn-i.

Russia's largest companies are unlikely to default as rates climb, said Ekaterina Trofimova, a credit analyst at Standard & Poor's in Paris. Standard & Poor's raised ratings on 19 Russian companies this year and cut only two, Bloomberg data show.

The extra yield investors demand to own Russian bonds rather than U.S. Treasury notes rose 1 basis point to 1.45 percentage points, the third-lowest among the emerging markets in JPMorgan Chase & Co.'s EMBI Plus index. A basis point equals 0.01 percentage point.

40 Percent

Companies have 420 billion rubles of bonds with put options due between May and yearend, Bloomberg data show. Investors may redeem as much as 80 percent of so-called junk bonds on the put dates, said Nikolai Podguzov, a fixed-income analyst at Moscow- based investment bank Renaissance Capital.

Investors may demand repayment of as much as 40 percent of bonds rated investment-grade, or Baa3 and above by Moody's Investors Service and BBB- by S&P.

Tinkoff Credit System, a Moscow credit-card issuer partly owned by Goldman Sachs Group Inc. in New York, paid 18 percent, the highest for a Russian company, on 1.5 billion rubles of three-year bonds sold in October.

``We are suffering,'' founder Oleg Tinkoff said at an investment conference in London last month.

To contact the reporter on this story: Denis Maternovsky in Moscow at dmaternovsky@bloomberg.net