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. Last Updated: 07/27/2016

Russian Debt Called A Great and Safe Bet

The buzz on debt-trading floors is like music to investors' ears. A lot of gains in Russia are being made — and many more are to come.

Adding fuel to the bull run, Standard & Poor's on Thursday raised its long-term foreign and local currency ratings for Russia to B from B minus and short-term ratings to B from C. The international rating agency is keeping its outlook stable.

Standard & Poor's cited better prospects for reforms as a reason for the upgrade. But the agency indicated that the ratings continue to be constrained by significant institutional and administrative weaknesses, as well as the country's hefty debt burden and unclear refinancing prospects on international markets.

But the words of caution are likely to be shrugged off. Investors, eager to cash in on the Russian debt market, have been ignoring those caveats for the past couple of years.

"Russia's creditworthiness is much higher than implied by the prices," said Jerome Booth, head of research with Ashmore Investment Management, a British-based asset management company focusing on emerging markets.

Russian debt has been rallying ever since the 1998 financial crisis. In 1999 and 2000, it was just an oil story, but now interest goes far beyond following the dynamics of benchmark Brent prices on the International Petroleum Exchange in London.

Tax and judicial reforms, a pledge to honor all debts and, among recent events, a reshuffle at Gazprom and the summit between President Vladimir Putin and U.S. President George W. Bush have combined to give Russia a place of its own in emerging markets.

Local paper, which shot up 25 percent to 30 percent since year start, has not yet reached the dizzying heights of 1997 and 1998. But market watchers are telling investors to buckle into their seats and hold on tight.

"Generally, the story is quite solid," said Brett Diment, director of fixed income at Deutsche Asset Management. "We're still pretty constructive" despite recent gains and a likely correction.

How is the story solid? For example, the government in October 1997 was promising creditors interest of less than 10.5 percent on paper maturing in 2005, which then had a maturity of eight years. Now, bonds with a six-year maturity have a return of 10.8 percent.

By comparison, the U.S. Treasury is paying interest of 5.7 percent over the same period, while the British government is offering a return of 4.9 percent.

The Russian debt story goes far beyond technical gains, traders said. It is more about securing a new place in emerging markets.

"We are checking the levels against Brazil," said a trader at a major investment bank in London who spoke on condition of anonymity. "By year end, Russia's 2030 bond could be at par with Brazil." Brazilian debts maturing in 2030 yield 14.2 percent, while Russia's 30-year paper bears an interest of 14.6 percent.

A year ago, Russia was at the high end of the curve in emerging markets, with only Ecuador considered riskier. But now the country is perceived as a safer haven than Argentina, Turkey and several other emerging economies.

"It's a diversification play," said the London-based trader. "Big index players have to reduce their exposure to Argentina, Brazil and Turkey and buy something else … [and] there aren't many alternatives [to Russia]."

There are two key indexes to watch in the debt market, and traders see them both as putting Russian debt in a good light. J.P. Morgan's Emerging Markets Bond Index, or EMBI+, which tracks emerging debt instruments, rates Russia as by far the best performer this year with a return of 104 percent. Russian debt is ranked at 170.89, just a fraction below the all-time high of 193.13 hit March 23, 1998.

EMBI+ picks Ecuador as the second- best performer this year. The index is up 28 percent to 216.23 since Jan. 1.

But the Lehman Universal Index, which tracks the performance of global debt assets traded on secondary markets, is the main source of inspiration for emerging-market traders.

Briefly, the Lehman Universal Index is weighted as such — it allocates 84 percent to U.S. debt securities, 5 percent to high-yield bonds, 5 percent to euro-dollar debt, 4 percent to emerging-markets debt and 1 percent to 144A issues and collateralized mortgage-backed securities.

What makes traders excited is that 4 percent for emerging markets. The reason: U.S. pension funds.

"The U.S. pension funds had 15 spectacular years, except for the last 18 months," said Ashmore's Booth. "Now they are beginning to look at countercyclical, low-correlation assets, of which emerging-market debts are good evidence."

A switch to emerging-market debt could bring in $20 billion to $40 billion in new cash over the next year or two, according to a recent study by Lehman Brothers.

"If the weighting of an instrument is 1 percent, you can ignore it, but if it's 4 percent, you have to invest," said Booth.

A reallocation of assets from U.S. pension funds recently started, but in two to three years its effects will begin to weigh in on emerging markets, he said.

"This is going to be a major driver," Booth said.

Among those who now plow money into Russian debt are emerging-market funds, Russian banks and some crossover accounts, those investors who buy investment-grade paper but purchase risky assets using left-over cash.

Industry insiders say the growth of the debt market is much more stable than that in the 1997 bull run, when hedge funds moved hundreds of millions of dollars in and out of the market daily.

"There is very little leverage in the market," said a trader at another London-based investment bank. "It has become much more mature."