LONDON: Some of the highest inflation-adjusted yields in the world may not be enough to protect Russian bonds from the rouble sell-off that has gripped markets since the United States imposed tough new sanctions.
The rouble had dropped almost 10 percent since the end of last week and 10-year bond yields are up around 60 basis points, leaving investors exposed to Russian OFZ, as the Treasury bonds are known, licking their wounds.
The trade was a popular one - before the sell-off, more than 70 percent of emerging debt funds were "overweight" OFZ relative to Russia's weight in the GBI-EM bond index, and 95 percent were overweight the rouble, Morgan Stanley estimates.
Foreigners owned 65 to 80 percent of long-dated Russian debt, the bank noted, while Russian central bank data from early-February showed non-residents owned some 34 percent of the market, worth almost $40 billion.
The bonds were popular with foreigners because of a "real" yield of over 450 basis points, the highest among big emerging economies. Despite Russia's declining inflation - now well below authorities' 4 percent target - the central bank has cut interest rates very gradually to 7.25 percent.
Those yields had helped investors earn year-to-date dollar-based returns of around 4.5 percent by end-March, JPMorgan data showed. But this week's rouble rout would have wiped those out.
Analysts say emerging market investors are unlikely to have hedged currency exposure, first, because they expected rouble appreciation to augment total returns and second, because hedging costs would have significantly eroded the "carry" they were earning from high yields.
"Given how stable the rouble has been in past months and how strong Russia's external balances are, a lot of investors would have entered the market unhedged, which is probably why you are seeing this reaction -- there is a lot of unhedged exposure," said Kiran Kowshik, a strategist at Unicredit.
"Yes, there is a yield cushion, but it assumes there are no losses on your capital; such a loss can come from the rouble side if you held the bonds unhedged."
Morgan Stanley noted that investors' knee-jerk reaction had been first to cut currency positions as that was the main detractor from performance, and predicted that "the next reduction could happen in OFZs".
It was removing its long-standing positive stance on OFZ, it said, while another bank, JPMorgan, told clients it had put its "structurally bullish view on (Russian bonds) and FX on pause".
The Russian finance ministry, possibly fearing a lacklustre take-up from investors, cancelled its weekly bond auction on Wednesday.
So how big could the damage be?
If all foreign money bails out, yields will rise 100 to 150 basis points, according to a note last December from Bank of America Merrill Lynch, which had highlighted extended sanctions as a "black swan" risk for 2018.
Some see the fears as overblown. Renaissance Capital said the rouble at 60 per dollar would add 0.4 to 0.5 percentage points to headline annual inflation, leading to an end-2018 figure not out of kilter with its original 3.5 percent forecast.
It really boils down to the rouble. The currency is some 11 percent cheap on a REER basis -- against trade partners' currencies and adjusted for inflation -- JPMorgan acknowledged. But it also noted that emerging market losses tended to overshoot and saw the falls extending.
One reason the sell-off could go deeper is that unlike past sanctions, which only targeted new debt and equity, the latest ones bar investors from holding existing securities in sanctioned companies. That is prompting fears government debt is next in line.
And if rouble weakness passes through to inflation, the central bank will have to pause, if not reverse, its rate-cutting cycle. Finally, authorities have effectively signalled they will not stand in their floating currency's way.
Paul Greer, assistant portfolio manager at Fidelity International, said those trapped in a falling Russian market had no choice but to quickly sell the most liquid of assets to minimise losses - the currency.
"The tail risk of (sanctions on the sovereign) has increased and that change has been reflected in market pricing," he said.
"So investors will continue to hedge by selling the currency. I expect the rouble to depreciate and local debt yields to continue to go up to reflect the increased risk premium on Russia."
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