This week’s bond presents a rare opportunity to combine high-yield with one of the world’s most desirable and highest quality currencies. Russian Railways, the national rail company in Russia, has a Swiss franc-denominated bond with a current yield indication that is about 7.8%, and maturity in a relatively short 35 months. The rail system is the lifeblood of the Russian economy. This natural monopoly is not only essential to passenger travel in Russia, but more importantly, to the movement of freight. According to recent figures, 85% of all freight transport in Russia is via rail. Furthermore, Russian Railways is responsible for a market commanding 42.3% of the country’s freight transportation. More impressive is the fact that Russian Railways owns all of the property and physical structures that make up the national rail system. This translates to payments from other competing freight companies for the use of their system and equipment. With limited roads and highways, the rail system provides basic, daily transportation for Russian citizens as well as transportation of goods for internal consumption and commodities for trade and export. Russia’s central government, as 100% owner of the company, provides certain and systematic support via subsidies and capital infusions.
For investors that seek to minimize risk through currency diversification, including the “safe haven” of currencies, the Swiss franc, is essential to any well-balanced portfolio. Therefore, we are looking to add these high yielding, Ba1/BB+ rated bonds from Russian Railways, priced about 85.75%, to our FX2 and FX3 global income portfolios.
Bonds in Desirable Swiss currency
These bonds have been issued in Swiss francs, one of the most desired currencies in the world. When several peripheral countries were in need of bailouts during the Eurozone debt crisis (about 4 years ago), investors ran from euros and moved into the Swiss franc, a traditional safe haven. After gaining about 28% (from about .70 to .90) since the beginning of the Global Financial Crisis, the Swiss National Bank (SNB) moved to peg the franc (CHF) to the euro (at .83) on Sept. 6th, 2011. The peg worked rather well, but not without costs. The SNB expanded its balance sheet to 80% of GDP and its foreign currency reserves doubled from around 250 billion to 500 billion. Concerned with the large expansion of money supply (at one point the SNB appears to have been buying nearly half of the new government issuance of the Eurozone), the SNB surprised the markets by removing the peg on January 15th of this year. This resulted in a quick 23% appreciation, an unprecedented move in the currency market. Perhaps the gold referendum in November, 2014 added some political pressure to tighten the monetary policy, or possibly the announcement of the QE in the Eurozone on January 22 was being anticipated by the SNB.
While an appreciating CHF does create additional risk in the old loans denominated in Swiss franc, the SNB also lowered the interest rate for balances held in deposit accounts from -0.25% to -0.75%, in order to deter the capital inflows and currency appreciation. Since its 1.02 peak in January, the franc has eased back to about .93 against the euro, and currently trades near par with a very bullish behaving US dollar. Looking at its longer 10 year trend, the Swiss franc continues to outperform the US dollar (see chart below.)
Barring a collapse in the Eurozone, it’s likely for the Swiss franc exchange rate to trend sideways to the euro in the coming months. However, unwinding the SNB’s enormous foreign currency reserve from its bloated balance sheet will be no small or easy task, which may mean many years of an upwards pressure pushing against the CHF currency.
About the Issuer
Prior to Russian Railways ownership, the Russian rail system was in need of capital investment for upgrades and modernization. The country created a three stage reform program to meet Russia’s increasing economic demands on the railways. After successful completion of the first stage in 2003, the Russian Railways Public Corporation was established. The company continues to be 100% state owned.
Today, Russian Railways is one of the largest transportation companies in the world. It is Russia’s largest commercial employer, with nearly a million employees. It is the owner and operator of Russia’s approximately 85,200 kilometer-long rail system and related infrastructure. Its rail system is the world’s third longest railway network, the world’s third largest railway in terms of freight turnover (measured in tons per kilometer) and the world’s fourth largest railway in terms of passenger turnover (measured in passenger per kilometers). In addition to the rail system, the company owns and operates nearly all of the locomotives in Russia; is one of the largest Russian owners, operators and lessors of freight rolling stock, and carries virtually all long-haul (trips over 200 kilometers) railway passengers.
Russian Railways continues to grow internationally as well as domestically. The company has recently signed an agreement with France’s state owned rail company, SNCF, to help construct a night train for transportation inside France. It is also participating in a joint venture to build key infrastructure projects within Egypt.
Natural Monopoly in Rail Transportation
Russian Railways has an enviable position as a natural monopoly. The company owns and operates the rail system, as well as virtually all of the locomotives throughout the country. By Russian law, it is required to provide access to the railway infrastructure, locomotive services and Company-owned railcars to all market participants. The company has the leading position in the Russian railway freight transportation market and passenger market, responsible for 42.3% of Russia’s total freight traffic and more than 32% of the country’s passenger traffic.
Essential Service for Russian Economy
Russian Railways provides an essential service for the country’s economy. Because of the country’s huge territory and vast natural resources, a highly developed railway system is vital to Russia. Over 85% of the nation’s freight is transported via rail. In addition, many of Russia’s natural resources are in remote, harsh and sparsely populated regions of Siberia and the Russian Far East that have underdeveloped road infrastructure and are far removed from the main population centers in Europe and Russia. Russian Railways contributes vital freight transportation to not only provide access to goods for Russia’s population, but more importantly, transports Russia’s extensive natural resources for trade and export. Additionally, rail is the main mode of transportation for a majority of Russia’s 143 million residents. With an average of 260 personal vehicles per 1000 people, Russians rely on trains for their basic, daily transportation needs.
Russian Railways has an excellent EBITDA margin. For the first six months of 2014, the company had revenue of 865,233 million rubles and EBITDA of 167,116 million rubles for and EBITDA margin of 19.3%.
The company also has extensive investments in its plant, property and equipment. Russian Railways is the second largest property owner in Russia behind the Russian Federation itself. As of June 30, 2014, plant, property and equipment assets were valued at USD $49 billion.
As a key player in Russia’s infrastructure, the impact of Russian Railways on Russia’s economy is significant. It is Russia’s fourth largest company by revenue, and in 2013, it was one of the largest single contributors to the country’s GDP, with annual revenues representing 1.6% of Russia’s GDP.
Russian Railways continues to make capital improvements to its operations. In 2014, it invested 49.9 billion rubles to modernize and increase capacity of its networks in Eastern Russia. It currently employs nearly 1 million people.
The default risk is Russian Railways ability to perform. The company has a key position in the transportation of goods and passengers as well as a natural monopoly of the country’s rail assets. In addition, due to its 100% state ownership, the government provides regular support through subsidies and capital injections for railway infrastructure and development. In light of these factors, we see the default risk comparing reasonably equivalent to Russian sovereign debt risk.
As these bonds are denominated in Swiss francs (CHF), there is a level of currency risk present in the exchange rate between the franc and the US dollar. Earlier this year, the Swiss National Bank’s decision to discard the exchange rate cap between the Euro and the franc resulted in a period of volatility between the CHF and other foreign currencies. However, the resulting volatility between the USD and the CHF has been somewhat normalized in recent weeks. We acknowledge that a stronger US dollar would directly reduce the total returns of this Swiss bond. However, if the dollar resumes its longer 10 year path of relative weakness to the Swiss franc, this may add significantly to the positively accruing returns of this bond.
Perhaps the most difficult risk to quantify is geopolitical risk. From a default perspective, Russia has recently experienced challenges on the economic and political fronts. With oil being a major export for the county, and current low price oil environment, along with the country’s continued struggles with neighboring Ukraine, one might conclude that investment in the midst of such uncertainty might be unwise. However, Russian Railways represents an absolutely vital and essential piece of the Russian economy.
From a Swiss perspective, global geopolitical events could actually work in favor of increasing the returns on this bond. In times of global economic uncertainty, Switzerland has historically been, and continues to be the safe-haven for investors. This scenario has been played out many times in recent history. For investors with Swiss-franc denominated investments, global, geopolitical uncertainty has often translated to increased returns.
Summary and Conclusion
From an investment perspective, a company with a virtual monopoly in the marketplace is highly desirable. Through its ownership of Russia’s sprawling rail system, Russian Railways is the dominant player in Russian rail transportation, for both passenger and freight traffic. Geopolitical events can make investors hesitant to invest where they might perceive economic turmoil or unrest. The hidden benefit for savvy investors is the realization that these same events have the ability to drive yield, as is the case for these Swiss franc denominated bonds. Consequently we believe the currently indicated 7.8% yields of these less than 3 year bonds from Russian Railways make an excellent foreign currency addition to our high yield global fixed-income1 and fixed-income2 portfolios.
Issuer: Russian Railways
Price: 85.75 (3/18/15)
Yield to Maturity: ~7.8%
Disclosure: Durig Capital and certain clients may have positions in Russian Railway 2018 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.
To know more about this Swiss Currency Russian Rail Raod bond, call our fixed income specialist at 971-327-8847
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