Heavily overweight in the ruble-denominated state treasury bonds, traders dumped RUB500bn worth of these OFZ last year afraid the US government was going to ban trading, and even ownership, of one the most rock solid and highest yielding fixed income instruments in the world. The threat of new sanctions is still there, but in the last few weeks bond traders have snapped up OFZ in record amounts. The game has changed.

Ever since the global financial crisis struck in 2008 and central bankers around the world cut interest rates to near zero, yield-hungry bond traders have been scouring the world for fixed income assets that pays a decent return. It has not been easy as the only bonds with high yields are also very risk. Not so in Russia. For bond traders sanctions have been a boon, driving up yields, while the risk of default from the usual reason of a state running out of money, is extremely low. The bet is now entirely on if the US will target OFZ ownership as part of an expanded sanctions regime.

During his recent state of the nation speech Russian president Vladimir Putin boasted that for the first time ever Russia can cover its debt dollar-for-dollar with cash. Despite several economic crises in the last decade and anaemic economic growth, Russia has managed to rebuild its currency reserves, which stood at $476bn as of the end of January – the third largest reserve in the world.

Russia has never defaulted on its obligations and even in the 1998 financial blowout it restructured its GKO bonds, a precursor to the OFZ, delaying payment by five years, rather then outright defaulting on them.

And they pay well too. At the peak foreigners held 34% of all the outstanding OFZ last April, before the rout began, bring their share down to 24% by the end of the year. Demand fell so much that the Ministry of Finance had to cancel several auctions for the first time in years. During this time yields rose from circa 7% to touch on 9% last autumn. Even though yields have fallen back somewhat since then the OFZ still pay over 8% -- the same return investors expect from long-term equity investments.

But the selling has stopped. In the second week of March the Ministry of Finance managed to place its biggest tranche of OFZ ever as investors are “risk on” and yield hungry again, now it is clear the US Fed has stopped its monetary policy tightening and may even lower interest rates this year.

Changing the game

Since March 2018 the percentage of OFZ’s owned by foreigners has dropped precipitously and consistently. At its peak one year ago, the non-resident share of Russian local debt was RUB2.35 trillion ($36bn), whereas the most recent data has it at RUB1.70 trillion (~$26mn) as of February 2019

The sell-off by large institutional investors, such as Eaton Vance, Ashmore Capital, and Morgan Stanley, has contributed to the sizable drop in foreign ownership.

Many have pointed to the increasing possibility of US sanctions targeting Russian government bonds as one of the reasons behind the foreign bearish sentiment, but just as important, if not more, is the new dovish stance by the Fed that always fuels investment into emerging markets and Russia in particular.

According to Bloomberg Barclays indices, Russian ruble-denominated sovereign bonds are up 7.5% YTD while the ruble has returned 5.6% YTD. In fact, OFZ auctions on March 13 sold RUB91.44B of the sovereign bonds, the largest amount issued in recent years, with a three-year coupon of 8.02% and 10 year coupon of 8.47%. The auction was a triumph for the Ministry of Finance, but nonetheless, foreign investment still depressed compared to recent years.

Taking stock of equities

Despite the recent sell off in equity markets, the Russian focused funds are still ahead of the game.

The VanEck Vectors Russia ETF (RSX) is up 9.58% YTD, beating the iShares MSCI EM (EEM) benchmark, which has returned 8.91%. Strong yearly gains are in part a recovery from an abysmal fourth quarter of 2018 for emerging markets in general, but it seems as if the strong performance in Russia is not merely a relief rally. High demand for Russian securities has been supported by an increasingly insulated domestic economy and a famously conservative fiscal structure. Inbound investment has also been driven by the strong performance of crude, which is up 26% YTD, as well as a recently implemented hike to pension retirement ages that went into affect last summer.

Economic growth is still weak: GDP rose 1.8% in 2018, and will likely decelerate to 1.5% in 2019 in the face of higher domestic interest rates and VAT hikes. However, Russia is not at the end of the business cycle; interest rates were unexpectedly hiked in late 2018 for the first time since 2014 in a response to rising inflation. The CBR expects inflation to peak at 5.5% in 2019, before returning to 4% in 2020. Interest rates will likely be eased in late 2019, after inflation peaks and thevocally dovish central bank will likely drive demand for OFZ’s in the short to medium-term.

Sword of sanctions

The main concern of foreign OFZ holders is that the next round of US sanctions – Defending American Security Against Kremlin Aggression Act (DASKAA) due to go before Congress in April – will either limit secondary trading markets (mirroring the impact of the sanctions imposed on Venezuela in early February) or prohibit owning the bonds altogether. Just after the Venezuelan sanctions were imposed, global secondary trading of Venezuelan sovereign debt grinded to halt — the high concentration of trading within the US greatly complicated the buying and selling of Venezuelan debt on a global scale, leaving investors trapped.

Investors are worried that what happened to Venezuela will happen to Russia, but the two countries are not in the same position. Washington’s motivation behind sanctioning Venezuela’s national oil company PDVSA and Caracas’s sovereign debt was to squeeze the oxygen out of president Nicolas Maduro’s regime to cause a regime change. No one can reasonably expect the sanctioning of OFZ’s to lead to any major change in behaviour from Moscow. No wonder Putin was so happy to boast about his cash reserves: not only do they protect investors from default, they insulate Moscow from US political pressure and inure it to Washington’s bullying.

Still, limitations on American engagement with Russian debt will undoubtedly impact liquidity, sovereign yields, and the ruble; indeed they already have: those high yields OFZ pay are a result of the sanctions regime. But the CBR’s cash pile and low external debt mutes the impact of possible sanctions.

On top of this, American OFZ holders are more likely to bear the brunt of the pain caused by any penalties than the Kremlin. The bottom line is that Venezuela and Russia are in entirely different positions. Venezuelan was sanctioned, but that doesn't mean Russia will be.

Losing capital and passing up on opportunities are part of the investment game. The cloud of sanctions hanging over the Russian bond market has lead some to calling the bonds “un-analysable.” However, Russia’s domestic economic picture remains fundamentally sound. Making investment decisions based on exogenous events is speculative as the sanctions are unknowable and unpredictable. Any decision— buy, sell or hold —is a bet in itself.