Fixed Income - "New" OFZs: Early Bird Gets the Worm

Last week saw a R105 bln net inflow from nonresidents into the OFZ market, one of the largest inflows on record. Inflows into the "new," on-the-run OFZs were lagging the rest of market in July, as the nonresident share in these issues is still lower than in the nearest-dated "old" fixed-coupon issues. Since foreigners have been somewhat reluctant to increase their positions in them, the new OFZs trade at elevated spreads of 15 bps on average to the off-the-run curve. We believe that these premiums will inevitably compress, as ultimately a new OFZ becomes identical to an old one once the Finance Ministry finishes tapping it in the primary market. Below we lay out in a Q&A format why we find the new OFZs attractive. > What is the difference between "old" and "new" OFZs?This past April, the US introduced sanctions that prohibit US financial institutions from purchasing in the primary market bonds denominated in rubles and other currencies issued by the Russian Finance Ministry after June 14. In response to that, the Finance Ministry announced on the same day that it would discontinue its placement of outstanding OFZ issues starting June 14 so as to avoid compliance risks for existing holders. In the meantime, it voiced its intention to hold auctions only for newly registered issues after June 14. The market has therefore effectively been split into two categories - old issues, which were fully placed before June 14, and new ones, which were launched after June 14. > How do the "new" OFZs trade in the secondary market?Later in April, the US Treasury Department issued a clarification, saying that the imposed restrictions do not affect the secondary market for Russian government debt. At the beginning of July, Euroclear started settling the new OFZs, having sorted out technical issues. Still, depending on how strict and risk-averse their internal compliance is, we think foreign investors could have slightly different interpretations of the sanctions. As we understand, despite the lack of formal restrictions, some accounts have so far preferred not to trade a new OFZ in the secondary market until the Finance Ministry finishes tapping it in the primary market (typically, it takes multiple auctions to fully place an issue). > How active are nonresidents in the "new" OFZs in the secondary market?In money terms, the largest volume held by nonresidents in a new OFZ is R17.4 bln, in the 8y OFZ 26237 (March 2029), which corresponds to 17% of the issue. To put that in context, the foreign share in the nearest old OFZ (the 8y OFZ 26224; May 2029) is 54%. In the new 20y OFZ 26238 (May 2041), the nonresident share is 12%; in the 10y OFZ 26239 (July 2031) 7%; and in the 15y OFZ 26240 (July 2036) 25%. The average nonresident share in old OFZs longer than 10y is 34%.> Will the "new" OFZs be added into the GBI indexes?In our view, the new issues will satisfy all requirements for inclusion and should be included, as they exceed the size threshold ($1 bln). One of the issues - the 8y OFZ 26237 (March 2029) - already complies with that, having reached R100 bln outstanding after last week's auctions. Meanwhile, the new OFZs should also satisfy liquidity thresholds, as the local subsidiaries of foreign banks already actively trade them in the secondary market. In this regard, we also note that the new euro-denominated Russian sovereign Eurobonds were included in the EUR EMBIG after similar sanctions were imposed on Russia's external debt in 2019 (though the inclusion criteria are slightly different for the GBI versus the EMBIG indexes). > Where do the "new" OFZs trade relative to the "old" ones?The current spreads are 15 bps on average. The smallest yield pickup is in the 10y OFZ 26239 (July 2031) at 12 bps, while the most generous premium is in the 15y OFZ 26240 (July 2036) at 16 bps. The latter, along with the 20y OFZ 26238 (May 2041), offers the highest yield among all outstanding nominal OFZs at 7.18%. The 10y OFZ 26239 (July 2031) is our top pick. Nonresidents have historically overweighted the 10y segment of the curve relative to other tenors, so the new 10y paper should attract more foreign inflows than the other new OFZs. We also like the 15y OFZ 26240 (July 2036), which looks the cheapest among the new issues. > When will the premium to the "old" OFZ curve fade? We think the premium will gradually decrease on the back of two factors: first, time is simply needed for more nonresidents to get used to the new market paradigm; second, the Finance Ministry's auctions themselves should compress the spreads by improving liquidity and making the issues eligible for inclusion in the GBI indexes. Moreover, as soon as a new issue reaches its registered size limit, it becomes identical to an old one, regardless of compliance requirements. Around R1 trln remains to be borrowed this year, which implies that up to two of the five new issues could reach their size limit before the year-end. It is worth bearing in mind as well that the Finance Ministry is considering buying back floaters this year, possibly financing the transaction by placing more nominal OFZs. With the bulk of nonresident inflows concentrated in the 7-10y segment, we think the 8y OFZ 26237 (March 2029) and 10y OFZ 26239 (July 2031) will be tapped most actively moving forward, and they represent, in our view, the two most likely candidates to reach R500 bln in size by the year-end. > Could the R1 trln remaining to be borrowed this year result in elevated concessions at auctions and exert upward pressure on yields?We do not believe that primary market supply will be a factor pressuring the OFZ market, as the Finance Ministry has shown it can switch to more conservative tactics. For instance, recently the Finance Ministry had been setting limits for its auctions at just R20 bln (versus the implied weekly borrowing target of R50 bln) and managed to avoid large yield premiums. In addition, the remainder of the year will see some big redemptions, and many local banks could reinvest the proceeds into outstanding OFZs to keep the structure of their portfolios intact. In particular, there will be R700 bln of redemptions in August-December versus R200 bln in 7m21. Overall, the above-mentioned arguments, along with the improved market conditions, suggest that the Finance Ministry will continue to seek to avoid big premiums. This means the upcoming large placement volumes could be overall supportive for the new OFZs, as they will help improve liquidity. > How actively do "new" OFZs trade on the Moscow Exchange?Their trading volumes on the Moscow Exchange were relatively subdued in June and the beginning of July, typically below R2.0 bln per day (which corresponded to about 3% of the overall OFZ trading volume on the Moscow Exchange on average). However, volumes jumped over the last two weeks to R3.5 bln (8% of the overall OFZ trading volume on average). Especially active trading took place after the Finance Ministry's "no-limit" auctions on July 28 - in the following four sessions, R5-8 bln was traded daily in the new OFZs (13-19% of the overall market volume). > How is foreign positioning in OFZs evolving?The last two weeks saw large foreign inflows into the OFZ market, for a total net inflow of R150 bln over the period. The overall market share of nonresidents, however, recovered only marginally - to 19.2% from 18.9% at the beginning of July. Among nominal bonds, the foreign market share in the long segment of the curve in July remained unchanged at 22.8% (versus 28.2% at the beginning of the year); that in the belly increased to 25.6% in July from 24.0% (versus 29.9% at the beginning of the year). Typically, all nominal OFZs are added to the GBI indexes, so the low share of nominal bonds relative to 2020 may mean that many index-tracking accounts retain an underweight. Hence, there is still ample room for nonresidents to restore their positions, in our view.In the primary market, the share of foreigners and the local subsidiaries of foreign banks dropped to 9% in the second half of June from 25-40% in the first half, according to the latest available data from the CBR. However, the primary activity of foreign bank subsidiaries most likely increased at the end of July, judging by the NSD data.> What is the scope for yields to fall along the "old" curve? In our view, the fact that the CBR continues leaning toward the hawkish side of expectations, despite first signs of domestic inflation moderating, is positive for OFZs longer than 5y, as it reduces the longer-term inflation risks. In addition, in late June the CBR floated the idea of lowering its inflation target. As far as we understand, such a step could be intended to anchor inflation expectations at structurally lower levels. Elevated household inflation expectations were among the key concerns for the CBR at the last meeting - in July, one-year-forward expectations reached 13.4%, the highest in nearly five years. Last week, in an interview with the Financial Times, CBR Governor Elvira Nabiullina for the first time gave particular levels to which the inflation target could be revised lower - she said the CBR could begin discussing a possible reduction in the inflation target from 4% to 2-3% this September. In our view, these comments highlight the fact that the CBR is determined not just to rein in inflation but also to keep it at a level below the current target for some time. If the CBR indeed goes through with a downward revision to the inflation target, it could lead to a repricing of the nominal "neutral" rate, which represents an important anchor for back-end yields. As we noted above, the share of foreigners in nominal OFZs remains below levels seen at the beginning of the year. Meanwhile, the spreads of 10y OFZs to US Treasuries are at levels comparable to late September 2018, whereas the geopolitical backdrop looks more constructive now than at that time, in our view. Given this, we think the old 10y OFZ could reach 6.50% by the middle of 2022 in our baseline scenario (versus 6.90% currently), assuming a stable geopolitical backdrop. We find long US Treasury yields lower than justified by fundamentals, but the wider-than-average spreads of OFZs should protect domestic yields if the Treasury market undergoes a correction later this year.