Markets: Bonds that come from Russia with love

Russia is poised to be the next recovery story in emerging market debt as it arranges to repay loans it defaulted on more than five years ago.

The government and more than 400 foreign creditor banks are putting the finishing touches to a repayment package for $35bn (pounds 22bn) in defaulted loans and accrued interest - a plan that's been in the works since 1991 when the country first realised it couldn't pay its debts.

"It's the final chapter in Russia's return to the international capital markets," says Daniel McGovern, head of emerging-markets fixed-income research at Merrill Lynch & Co.

Russia's rehabilitation began in November, when it secured its first credit ratings and sold $1bn worth of five-year Eurobonds, its first international bond in five years. Investors are so keen to lend to the nation that the government raised a further $3bn in the following six months, and plans to raise another $3bn in bond sales next year.

Now, Russia and the London Club of foreign creditor banks are close to completing the "reconciliation" - or agreement on the exact amount of defaulted debt and interest owed to each lender. The latest forecast for completion is the end of the month.

When 90 per cent of the debt is reconciled, the deal will close: creditors will exchange the defaulted loans for cash and two kinds of bonds, and Russia will join the ranks of countries such as Brazil, Argentina and Poland that rebuilt their economies and restored investor faith in their creditworthiness.

Those who kept the faith have seen the value of their Russian bank loans rise to about 102 per cent of face value, up from just 20 cents on the dollar two years ago. Moreover, they're not selling yet, in the belief that prices will go higher still.

"A lot of people are underweight, and will add to positions so prices can still go up. I would recommend to hold," said Oliver Dittrich, who runs the Russia portfolio on CreditAnstalt Bankvereign AG's proprietary trading desk in Vienna.

CreditAnstalt, he said "has been heavily invested in Russia from the beginning", which suggests the bank has seen the return on its Russian investments grow five-fold.

For Russia, whose entire political and economic structure collapsed in 1991 with the dissolution of the Soviet Union, rebuilding is far from complete.

Russia stopped making payments on $24bn in bank loans to some 420 banks around the world in early 1992. Even as it faced bankruptcy, the government tried to keep creditors sweet - and secure future access to the international capital markets - by starting negotiations to reschedule the debt as soon as it became clear it would miss its next payment.

"In the first three years (after the collapse of the Soviet Union) the country was in complete turmoil. It had to recreate all the financial institutions and simply didn't have the wherewithal to make payments," McGovern said.

Prolonging and complicating the negotiations was the amount and variety of debt to be rescheduled: 20,000 loans denominated in 15 currencies.

While investors with a taste for risk continued to purchase Russian assets in recent years - buying Russian companies, domestic securities and international debt - mainstream investors only got interested about six months ago. The inspiration was a 6 March speech by President Boris Yeltsin which, in a first for a Russian premier, "talked about the economy, not about politics", said Michael Marrese, an economist at Chase Manhattan International Ltd.

The speech, and Yeltsin's appointment of a new government, marked "a generational change. Now there are young people running the government," with a mission "to solve the fiscal crisis and promote economic growth," he said.

This year, prices of Russian assets - from defaulted bank loans to its Eurobonds - have soared.

Investors demanded a 345 basis point yield premium to buy Russia's $1bn of 9.25 per cent 2001 bonds, rather than US Treasuries, in November. Now, they'll settle for less, buying at a premium of under 245. The yield on its 10 per cent 10-year bond, 375 basis points above Treasuries when it was sold in June, is down to a premium of just 318.

Russia still has a long way to go to overhaul its economy. Even the government, which month after month predicts a revival in the economy, cut its gross domestic product forecast for the year, and now expects no growth or even a decline of 2 per cent - making five consecutive years with no growth - instead of a gain of as much as 2 per cent.

Still "they've made tremendous progress this year", said Oliver Fratzcher, the chief Eastern Europe economist at Deutsche Morgan Grenfell who reckons progress in reducing the budget deficit and lowering inflation, combined with a completion of the debt rescheduling, might put Russia in line for a higher credit rating.

Arjo Blok, who manages ABN Amro's emerging markets debt portfolio, said that while prices are getting a boost from progress on debt rescheduling, "the global search for yield" is pushing Russia and all emerging market debt higher. He sees Russian prices rising more, and is holding on to the loans.