Alexandr Popov, State Management Company VEB: “If money is worth something we’ll show yields above inflation”

VEB Trust Management Department Director ALEXANDR POPOV told RBK daily’s observer ALBERT KOSHKAROV why they can’t outplay inflation so far despite the state management company’s new strategy and what new instruments they should use to protect future pensions

Last year, State Management Company VEB outplayed private management companies posting pension savings yields a bit lower than inflation. And the portfolio of government bonds demonstrated better financial performance than the extended portfolio where besides OFZs VEB’s managers were allowed several years ago to use more risky instruments. VEB Trust Management Department Director ALEXANDR POPOV told RBK daily’s observer ALBERT KOSHKAROV why they can’t outplay inflation so far despite the state management company’s new strategy and what new instruments they should use to protect future pensions.

Negative Value

- How do you size up the results of investing pension funds in 2011 and why did VEB fail again to outplay inflation?

- You can outplay inflation, given conservative strategy of investing, only in the case that the value of money in the country is positive. Here I mean a difference between inflation proper and yield rates of OFZs (federal loan bonds). But in our country the real value of money has been negative maybe for more than ten years. This happens because of excessive short-term liquidity and this is not normal in itself.

Of course we have also other investment instruments but last year even corporate bonds of companies with BBB-rating had negative real yield rates in the first half of the year. It’s almost impossible to outstrip inflation under such conditions. We had yield rates above inflation for two times but in those years the market saw the decline in yield rates and VEB achieved a higher through revaluating its assets. But it’s quite clear that this sort of situation can’t occur every year. So, the only instruments that can enable us to outplay inflation even in case of negative money value are shares.

- So, your logic means that VEB can post yields above inflation only in crisis years?

- This is not the case. If there is no excessive liquidity on the market and money is worth something we’ll be able to show yields above inflation. This is a normal situation. For example in the US, despite of everything, yield rates of 30-year treasury bonds remain positive. Unfortunately, over decades of petrodollar inflows everybody got used to the fact that money was worth nothing. Maybe now we have a chance to reach a balanced condition. In the fourth quarter of the last year and now in the first months of the new year, yield rates of medium-term OFZs are outstripping inflation rates. Bonds are placed at an interest rate of 7%, with inflation rate being a bit higher than 6%. Under these conditions we are hoping that we’ll outplay inflation.

- Why does the extended investment portfolio which VEB obtained three years ago perform so far worse than the conservative one in terms of yield rates? Logically, everything should be quite the opposite because besides OFZs in your extended investment portfolio you have deposits, corporate bonds, mortgage credits …

- The fact is that long-term government bonds that used to be issued in 2004-2005 remained in the extended portfolio. And these OFZs have a significant impact on yield rates. There’s no chance of selling them because of their extremely low liquidity and their volumes are too big for the market. Sometimes, we have up to 70% of one and the same OFZ issue in our extended portfolio. And they generate a coupon yield of 6-6.5%. And because of these bonds long duration their revaluation has a significant impact on the portfolio’s value. If someone conducted ten transactions for an amount of 500 thousand rubles the value of our whole position changes in the amount of billion of rubles. Until we fail to build up the share of corporate bonds, this imbalance will remain.

Our conservative strategy looks better so far because we started to form a portfolio of government bonds in late 2009 and new, more liquid OFZ issues were included into it. Besides long-term government bonds we also purchased medium-term bonds and the portfolio proved to be more balanced in terms of duration and yield rates. It is for this reason that the portfolio of government bonds is less sensitive to fluctuations caused by revaluation. We used to have and have now a chance to choose the most profitable corporate bonds guaranteed by the state.

- Why wasn’t VEB active enough in using deposits, interest rates on which exceeded inflation, as early as in the second half of the year? Since the beginning of the year the amount of deposits has only increased from 58.6 billion to 139.4 billion rubles.

- Deposits are not investment instruments for us – above all, they are instruments for managing liquidity because VEB is a long-term investor. First significant payments are to start only in 2022 and it’s a long period of time before this date. You can place a deposit for a year at most. Nevertheless, we have the right to reinvest in deposits in the crisis periods on the market.

At the end of the year we of course noticed that interest rates on deposits had increased and we started to place funds with banks at interest rates that were a lot higher than OFZs, annual deposit income on some transactions exceeded 10%. This year we decided to try to place money for a period of one month. An auction was not conducted for understandable reasons. The matter is that in accordance with applicable legislation we have the right to place money at an interest rate that will not be lower than a yield rate of OFZ issue nearest to repayment. The nearest bond issue to be repaid is in July, that is, in five months and the liquidity deficit has now somewhat declined.

- In your comments to RBK daily you said that a significant part of funds received by VEB from the Russian Pension Fund was in the form of OFZs. How did it in the end influence the portfolio yield rates?

- The Russian Pension Fund was in the hopeless situation. In view of the change in legislation in 2011, the Fund not only transferred funds for actually two years and a half (contributions for 2009, 2010 and the first half of 2011) thus factually doubling the state management company’s extended portfolio but had to address an extremely complex objective of moving from annual to quarterly transfer of funds into management. So, the Pension Fund was closing its portfolios of pension savings temporary placement (insurance contributions before their distribution among management companies and non-government pension funds – RBK daily) which it was allowed to form exclusively from OFZs.

It’s quite clear that it’s almost impossible to sell such a significant amount of OFZs worth about 300 billion rubles irrespective of a situation on the market. We received first tranche worth about 200 billion rubles from the Pension Fund in February and the second one in August. But as early as in September, OFZ prices fell on the market and 300 billion rubles we received in the form of OFZs brought significant losses for us as a result of their negative revaluation.

In the end, despite the fact that under our strategy we planned to reduce the share of government bonds in our portfolio and build up investments in corporate bonds, in fact the share of government bonds increased a little and the share of corporate bonds fell from 17 to 14.5%. Although in the absolute terms we almost doubled our investments in non-government bonds to 200 billion rubles. The Russian Pension Fund didn’t have any other way out and we fully agree with the Russian Pension Fund that the transfer of funds in the form of OFZs was an extreme, exclusive measure.

- Are you focusing on bonds with long or short duration?

- As far as corporate issuers are concerned we are omnivorous. But we give top priority of course to long-term bonds. Last year, we were catastrophically short of bonds, a burst of activity on our domestic debt market is seen only at year-end. We expect that a volume of placements will be larger than it was last year. This will allow us to restructure our portfolio reducing the share of OFZs.

In this sense we are in a better situation than non-government pension funds which, given formally long-term strategies, have in case of losses for one year to cover them using their own funds. To my mind this is an absolutely wrong situation. One must not make market players compensate for arising losses annually.

I hope that pension legislation will change in favor of management companies and non-government pension funds and will encourage them to make long-term investments. Maybe we could solve this problem partially by setting up a guarantee fund. There is a need for mechanisms allowing to compensate for losses upon occurrence of insurance event.

Guarantees and investments

- Is VEB also going to participate in a guarantee pension fund?

- We are going to participate. Is there any other way of setting up a guarantee fund?

- So, it turns out that you are ready to pay for the whole market?

- If contributions are to be paid depending on the amount of assets under management and we have more than 75% of pension savings it turns out this way. Although judging by the results of the last year we again expect a great deal of pension funds to flow into management companies and non-government pension funds. But we should also decide what we are going to guarantee, if we mean contributions made by employers or in case of co-financing by workers and the state then the amount of this guarantee fund must not be very large. Because I don’t think that taking into account profits generated by non-government pension funds and management companies for many years they won’t have enough money to pay off their customers: for this to happen, all the profits generated for 15-20 years should simply go down the drain overnight.

In my opinion the best way is for non-government pension funds and management companies to allocate a part of profits to the fund in good profitable years. To my mind it’s unjust to insured citizens to make contributions from the existing pension savings.

- How do you feel about having a greater number of instruments allowed for investing pension savings funds? What assets are you interested in?

- There are enough opportunities for investing now. I for one don’t think that it makes sense to invest in foreign securities because in principle we must use pension funds to develop the Russian stock market. So, we don’t need any additional investment instruments at this stage in our capacity of a state management company. It’s a lot more important for us to be able to hedge our risks. Without it we have problem making long-term investments…

Since January 1, 2012, non-government pension funds are allowed to use derivative instruments upon investing pension savings. And the Federal Service for Financial Markets almost denied management companies an opportunity to use derivative instruments as a separate asset for investing. All the derivatives are pegged to bonds of non-government pension funds that they have in their portfolios. I can’t understand why state management companies and other institutions responsible for managing financial resources of the Russian Pension Fund are denied an opportunity to use derivatives.

- Aren’t you afraid that if VEB starts buying futures, options and swaps this would mean that you start trading actively on the stock market: the market won’t have enough liquidity for such a huge amount derivatives?

- It’s clear that the derivative market is increasing but not at such rates that would allow us to hedge an OFZ position for an amount of 400 billion rubles. This will never happen because a full hedging means that you generate zero yields. But we might insure interest rate risk in certain long-term issues of government bonds. We’d like to try swaps and at some moments to change a fixed rate into a floating one…

- But now this issue is not that important. We’d like to have an opportunity to insure currency risks. Without it we can’t normally conduct transactions with sovereign eurobonds. It turns out that when we buy such bonds we immediately not only incur interest rate but also currency risks. Normally, when eurobond prices are on the rise the ruble is on the rise too and on the contrary – when eurobonds fall the ruble falls too. And this in the end has a negative impact on any yield rates. If we had an opportunity to hedge currency risks through swaps, through forwards, through stock futures it would be a lot easier for us to manage such instruments thus diversifying our investment portfolio.

- How do you view the idea to invest pension funds in infrastructure companies’ bonds, in bonds of such quasi-state companies as for example RZHD?

- So far we have been investing in the bonds that are on the market. Unfortunately, they are not that many. They include state-guaranteed bonds of such special companies created to implement specific projects as OJSC The West High-Speed Diameter, LLC North-West Concession Company. We also invest in guaranteed and unguaranteed bonds of such infrastructure companies as OJSC RZHD, OJSC UES FGC, LLC Avtodor, Vodokanal.

We are especially interested in inflation-indexed coupon bonds. Of these bonds we have only bonds of North-West Concession Company. Last year it issued bonds with a yield rate of inflation +3%. This is an ideal option for us because state management companies’ and non-government pension funds’ primary objective is to protect pension savings against inflation.

We are very happy that in view of reduced inflation OJSC RZHD is exploring the opportunity to raise funds for some specific commercial projects through issuing inflation-indexed coupon bonds, that is, a coupon will be equal to inflation plus a premium. Unfortunately, due to limitations we won’t be able to buy more than 30% of a bond issue but we’d like to buy a lot more. We have already sent letters to the authorities where we proposed them to introduce changes in our extended portfolio’s investment declaration in order to increase our participation share in a single bond issue of first-class issuers at least to 60% and lift other legislation restrictions, for example, a limitation to purchase no more than 20% of all circulating bonds of a single issuer.

- To what extent does an outflow of pension savings funds influence VEB’s policy?

- This is a normal process, and it does not have any serious impact both on liquidity and our yield rates. The only problem for us is that we can’t project the amount of pension funds to be transferred to non-government pension funds and private management companies. We can’t do it on the basis of the number of applications because there might be beginners with almost nothing in their accounts and there also might be people who have been saving up since 2002. So, at the start of year we place funds on deposits on the assumption of a potential maximum of funds to be transferred to non-government pension funds and private management companies.

We could use some other instruments to make payments to management companies and non-government pension funds rather than deposits, for example, REPO transactions. And last year, we discussed such an opportunity with the Russian Finance Ministry and the Federal Service for Financial Markets but in view of the fact we can close REPO transactions only through using funds newly received from the Russian Pension Fund the amount of which is difficult to project, we have so far decided not to run these risks.