- In 2019, the yield on sub-federal bonds fell below the pre-recession level for the first time since 2013 amid the Bank of Russia’s lowering of its key rate. Last year the weighted average yield for initial placements decreased on average by 1 pp compared to 2018. The annual yield on bonds placed in late 2019 was lower than 7%, while annual coupon rates reached 6.5%.
- Nevertheless, Russian regions were unable to take advantage of these favorable market conditions to increase the duration of their debt portfolios. In 2019, the total volume of bonds placed by regions and municipalities was equal to that of 2018. Yet at the same time, both the number of placements and issuers decreased. The average maturity of new bond issues fell by four months to 4.4 years.
- Regions have lost interest in bonds mainly due to growth in budget income, which has reduced their need to resort to borrowing. The number of regions running budget deficits has almost halved compared to 2017. Account balances accumulated in recent years allow regions to finance deficits without raising funds through borrowing. Measures carried out by the Russian Ministry of Finance to reduce regional debt loads have also been effective.
- Regions preferred to take out bank loans as interest rates fell throughout 2019. Regions have practically no opportunities to carry out early repayment of bonds. Bank loans are more flexible from this point of view because they can be paid off in ahead of schedule should interest rates fall and then be replaced by much cheaper loans.
- It will still be possible for regions to switch from commercial debt to bonded loans in 2020, although a significant increase in the volume of placements is unlikely. Despite this, provisions added to the Budget Code of the Russian Federation in mid-2019 to ensure control over the debt load of regions and municipalities, and the stabilization of interest rates at their current low level may contribute to a certain increase in bond placements.
Russian regions are losing interest in bonds, despite favorable conditions
Although the conditions for making bond placements to raise long-term financing were extremely favorable in 2019, a boom in the placement of sub-federal bonds did not occur.
At the same time, 2019 was the Russian Ministry of Finance’s most successful year in terms of raising debt financing. Despite the federal budget surplus, net internal borrowing hit a new record at RUB 1.4 tln. The total volume of federal loan bond (OFZ) placements at nominal value in 2019 more than doubled compared to 2018 and amounted to RUB 2.1 tln vs. RUB 1 tln. The average maturity of OFZs placed in 2019 grew to 8.9 years (compared to 7.4 years in 2018).
In 2019, 80% of bonds placed had an ACRA credit rating. In 2018, this indicator was 72%.
It is noteworthy that there were only 15 placements — worth a total of RUB 96.75 bln — in the sub-federal and municipal bond market in 2019. As a result, the total volume of issues remained unchanged from 2018, but the number of new placements in 2019 fell by a quarter. Besides initial placements, 2019 also saw two additional placements of bonds that were first issued in 2017, to a total of RUB 19.5 bln.
Figure 1. The peak in placement volume over the past six years was recorded in 2017
Sources: cbonds.ru, ACRA
In 2019, only nine regions and two municipalities decided to issue new bonds. The Belgorod Region, Moscow Region, and the Republic of Sakha (Yakutia) entered the bond market twice. The city of Tomsk issued exchange-traded bonds and bonds for the general public. For comparison, 14 regions and one municipality made new placements in 2018, and in 2017 there were 29 regions and three municipalities. In 2019, only one issue was not placed in full — in November, the Novosibirsk Region placed 15% of an issue with an annual yield of 6.7%.
ACRA notes that major issuers played a bigger role last year, with the share of a single issuer in the total nominal volume of sub-federal and municipal bonds placed in 2019 reaching 40%, its highest since 2013. For comparison, this share was 25% in 2018 and 21% in 2017. The four largest issuers (the Moscow and Nizhny Novgorod Regions, the Republic of Sakha (Yakutia), and the Krasnodar Krai) accounted for more than 70% of bonds offered in 2019.
In 2019, Russian credit organizations continued to serve as the primary investors in sub-federal bonds — they held around two-thirds of outstanding sub-federal bonds.
Figure 2. Only nine regions placed new bond issues in 2019
As the Bank of Russia cut its key rate from 7.75% to 6.25% per annum in 2019, the annual weighted average yield on initial bond placements declined to the minimum level for the analyzed period (since 2013) and amounted to 7.2%. Prior to the recession, in 2013, the annual weighted average yield was 8.1%. It was 8.2% in 2017, the peak year for sub-federal placements in the analyzed period. The annual yield on the last major placements of 2019, namely the Moscow Region’s five-year bonds and the Sverdlovsk Region’s seven-year bonds, was 6.7% and 6.9%, respectively. In December 2019, Tomsk placed RUB 1 bln of bonds with an annual yield of 7.6%.
The spread between the yield on sub-federal bonds and five-year OFZs averaged 0.8 pp in 2019, below 1 pp for the third year in a row (from 2012–2016 the difference between the aforementioned yields ranged from 1.4 to 2.2 pp).
Regions continued to place bonds for up to seven years in 2019, however more than half of these issues will be fully redeemed in no later than five years’ time. The average maturity of bonds placed in 20191 fell to 4.4 years, compared to 4.8 years in 2018, and 5.8 years in 2017.
1 Excluding bonds for the general public.
Figure 3. Bond yield was below the pre-recession level in December 2019
* The circles are proportional in size to placement volumes.
Sources: cbonds.ru, ACRA
Profit taxes made the biggest contribution to the growth of income of regional budgets, mainly due to high ruble prices for commodities. For more details, see ACRA’s research titled Budget surplus saved for the future dated February 22, 2019.
Sub-federal bond market: reasons for stagnation in 2019
Amendments made to Russia’s Budget Code in 2019 stipulate dividing the country’s regions into groups based on their debt to internal revenue ratio, share of debt servicing expenses, and the size of annual payments to service and repay debts relative to tax and non-tax revenue and dotations from the federal budget. Regions that are not included in the high debt sustainability group have to coordinate their debt policy with the Ministry of Finance.
There are a number of reasons for the low level of bond market activity among Russian regions in 2019. Firstly, growth in the income of regional budgets has reduced regions’ debt financing needs. As of 11M 2019, only 17 regions were running budgets with a total intermediate deficit of RUB 15.65 bln. For the same period in 2017, 29 regional budgets were in deficit, and 11 regions had deficits as of 11M 2018 (growth of internal revenues in 2018 allowed regions to increase their account balances by RUB 0.5 tln to RUB 1.9 tln, and they could utilize these funds in 2019).
Secondly, growth in the supply of sub-federal bonds was restrained by the federal government’s measures to support regions by reducing their debt loads. Regions required fewer new borrowings to refinance budget loans due to the obligations they entered into to reduce debt and extend deadlines for repaying budget loans.
The changes made to the Budget Code of the Russian Federation in 2019 to ensure control over the debt load of regions acted as an additional incentive for regions to reduce their total debt. As a result, a greater number of regions began to take measures to reduce debt in order to be classified as regions with a high level of debt sustainability.
For more details, see ACRA’s research titled Debt of Russian regions to remain expensive dated January 25, 2018.
In 2019, it became possible for regions to replace bank loans, which mostly have a repayment period of no more than three years, with long-term bonds. This would have minimized refinancing risks in the future, yet the majority of regions were unable to take advantage of it (as of December 1, 2019, regions’ bank loan debts stood at RUB 397.34 bln, four times larger than the total volume of sub-federal bonds placed in 2019). ACRA is of the opinion that this is due to complex procedures for placing bonds, complex buyback and/or early redemption procedures, and interest rates, which fell throughout the year.
Regions that placed bonds at 14–16% per annum in 2014–2015 were unable to refinance them after rates fell. But regions were able to repay bank loans early and then replace them with new loans at lower interest rates. In connection with this, and amid expectations of falling interest rates in 2019, many regions chose bank loans over bonds.
Outlook for the sub-federal bond market in 2020
For more details, see ACRA’s research titled Difficult to invest while reducing debt load dated December 9, 2019.
This year up to RUB 310 bln of sub-federal bonds are expected to be issued, judging by regional budget laws. In 2019 and 2018, regions planned to issue bonds with a total nominal value of RUB 250 bln and RUB 330 bln, respectively. However, the actual volume placed was 2.5–3 times lower — around RUB 100 bln. This trend is most likely to continue in 2020, with offerings of sub-federal and municipal bonds in line with 2018 and 2019 levels. Reasons for this include the significant reserves that regions have built up which will allow them to avoid major new borrowings (ACRA estimates that as of early 2020 there is more than RUB 2 tln in accounts). Growth in the number of placements may be limited by weak demand from investors for debt liabilities with a long duration under the current conditions of low interest rates.
Let’s take a closer look at the factors that could contribute to an increase in the volume of bonds issued in 2020. First and foremost, stabilization of interest rates at their current level would result in fewer regions forgoing bonds in favor of bank loans. Furthermore, long-term bonds could serve as an instrument for covering possible growth of regional budget expenses to finance investment projects to develop infrastructure (which involve an extensive return on investment period). The 2020 federal budget law allows regions that finance infrastructure development projects to prolong the repayment of budget loans until 2029 (regions can use up to RUB 30–40 bln for these purposes in 2020 as part of this budget loan restructuring).
Another new aspect of the Budget Code is the requirement that regions and municipalities that plan to place bonds must have a credit rating. The draft directive of the Russian Government that determines the minimum credit rating can be found at regulation.gov.ru.
The lack of limitations on the cost of borrowing could serve as an additional driver of the possible growth of the regional bond market. Regions that participate in the budget loan restructuring program cannot take out loans at interest rates that are higher that the key rate plus 1%. As a result, the share of unsuccessful auctions held by regions in 2019 to take out bank loans increased to 41%2 (in 2018 this indicator stood at 19%, while in 2017 it was only 5%). If it is not possible for regions to obtain bank loans without violating their obligations to the Government of the Russian Federation, they may decide to enter the bond market, which is not subject to such limitations.
Starting from 2020, the size of regions’ and municipalities’ annual payments to service and repay debts will be taken into account when assessing their debt sustainability. Refinancing bank loans using bonds, which usually have maturities that are two times longer than bank loans, will reduce the annual volume of such payments and lower the risks associated with refinancing.
2 Excluding the failed offerings of the Republic of Mordovia.