Russia failed to sell any 2016 ruble bonds at an auction today and issued less than 1 percent of its three-year notes after offering the lowest yields relative to market rates since it began providing guidance to investors three months ago.

The Finance Ministry cancelled a sale of 6.42 billion rubles ($209 million) of so-called OFZs due 2016 after investors demanded higher yields than the government was prepared to give, according to a finance official who declined to be identified in line with ministry policy. The Ministry offered a yield of between 7.25 and 7.40 percent for the securities in guidance yesterday, at least 30 basis points below the yield of 7.7 percent at the close of trading Dec. 13, data compiled by Bloomberg show.

“They seem unwilling to borrow at where the market is now which means they likely won’t succeed in the new placement,” said Nikolay Podguzov, the Moscow-based head of fixed-income strategy at VTB Capital, the investment banking arm of Russia’s largest bank.

Russian yields are climbing on concern the fastest inflation rate in 11 months will lead the central bank to boost borrowing costs. Yields on Russia’s 2016 OFZs were the highest since the bonds were first issued in August after jumping a record 47 basis points, or 0.47 percentage point, on Dec. 13.

Russia is holding off on its first sale of ruble- denominated bonds to investors abroad as the European debt crisis weakens demand for emerging-market assets, Deputy Finance Minister Dmitry Pankin said in St. Petersburg last week. The government will instead concentrate on building the domestic market, boosting ruble debt sales to 200 billion rubles in December, the biggest monthly target since September and more than triple the amount initially planned, he said.

‘Small Premium’

The increased bond sales won’t “force down” the price of OFZs, Pankin said last week. “We may give a small premium at auction, but no more than that,” he said.

In its first auction today, the government sold just 0.7 percent of 9.64 billion rubles of 2013 OFZs at a yield of 6.4 percent, the top end of the ministry’s guidance and 31 basis points below market rates yesterday.

The Finance Ministry would need to offer yields up to 5 basis points above the market rate to attract bondholders, Alexander Morozov, chief economist for Russia and the former Soviet Union at HSBC Holdings Plc, said by phone in Moscow yesterday.

“I fail to see the logic behind the Finance Ministry’s guidance,” Alexander Ovchinnikov, vice-president for global markets at Troika Dialog in Moscow, Russia’s oldest investment bank, said by e-mail yesterday. “I wouldn’t recommend buying the OFZs, I don’t see the potential for lower rates while the risk of them rising further is there.”

Budget Gap

The world’s largest energy exporter is issuing debt to help plug a budget gap the government forecasts will be 4.6 percent this year, only the second shortfall in 11 years. The government projects the budget will remain in deficit until 2014, spurring borrowing. The increase in December OFZ sales is being prompted by government plans to make 20 percent of its annual expenditure in the last month of the year, Pankin said last week.

“The market is worried that the Finance Ministry said they plan to place 200 billion rubles, that’s a lot for the last few weeks of the year,” Maxim Tishin, who helps manage $850 million of debt and equities at UFG Asset Management in Moscow, said by e-mail yesterday. “Talk of rate hikes early next year” is also damaging demand for OFZs, he said.

Traders are pricing in 73 basis points of Russian rate increases in the next three months, according to forward rate agreements tracked by Bloomberg.

Brazil has raised its benchmark rate, the Selic, three times since April 28 to 10.75 percent. The yield on the South American nation’s local-currency bonds due 2015 has climbed 58 basis points since it was issued in September.

Rates Rising

Speculation of higher interest rates helped the ruble rally this month, bringing its advance against the greenback to 2.6 percent. The ruble gained for a third day, adding 0.1 percent to 30.6325 per dollar by 3:50 p.m. in Moscow. The currency, which is managed by the central bank against a dollar-euro basket to limit swings that erode exporters’ competitiveness, slid 2.2 percent versus the dollar in November, its biggest monthly decline since May.

Non-deliverable forwards, which provide a guide to expectations of currency movements and interest rate differentials and allow companies to hedge, showed the ruble trading at 30.9056 per dollar in three months, the weakest this week.

Extra Yield

Russia’s dollar bonds due in 2020 rose, pushing the yield 2 basis points lower to 5.056 percent. The extra yield investors demand to hold Russian debt rather than U.S. Treasuries rose 11 basis points to 201 today, according to JPMorgan EMBI+ indexes. The difference compares with 130 for debt of similarly rated Mexico and 161 for Brazil, which is rated two steps lower at Baa3 by Moody’s.

The yield spread on Russian bonds is 33 basis points below the average for emerging markets, the widest since Nov. 22 yet down from a 15-month high of 105 basis points in February, according to JPMorgan.

The cost of protecting Russian debt against non-payment for five years using credit-default swaps is little changed at 142 today, down from this year’s peak of 217, according to data provider CMA. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements.

Credit-default swaps for Russia, rated Baa1 by Moody’s Investors Service, its third-lowest investment grade rating, cost 13 basis points more than contracts for Turkey, which is rated four levels lower at Ba2. Russia swaps cost as much as 40 basis points less on April 20.

‘Sit and Wait’

The Finance Ministry doesn’t need to raise all of the 200 billion rubles targeted as it can dip into its $40.9 billion Reserve Fund, said Dmitry Dudkin, the head of fixed-income research in Moscow at UralSib Financial Corp.

Officials “do not want to be moved by the recent sell- off,” Dudkin said in e-mailed comments yesterday. “This may result in the absence of demand, but it is unlikely that the Finance Ministry will be worried about it. It is wise for the ministry to sit and wait a bit.”

Annual inflation rose for a fourth month in November to 8.1 percent, the highest rate since December 2009. The pace may reach 8.4 percent this year, above the government’s 8 percent target, Bank Rossii Chairman Sergei Ignatiev said Dec. 8.

Cutting Rates

After cutting key rates 14 times between April 2009 and May this year to revive Russia in the wake of the global financial crisis, the central bank may raise borrowing costs in the first quarter of next year as rising consumer prices are “beginning to worry us,” Ignatiev said.

The central bank has a “free hand” to start raising borrowing costs, First Deputy Chairman Alexei Ulyukayev said in Munich on Nov. 29. The next rates review will probably take place on Dec. 24, according to Citigroup Inc.

Russia’s main interest rates -- which include the record- low 7.75 percent refinancing rate, the 5 percent rate charged on repurchase loans, and the 2.5 percent deposit rate -- are likely to be boosted in the first half of next year, German Gref, chief executive officer of OAO Sberbank, Russia’s largest lender, told reporters in Moscow on Dec. 13.

“The sell-off in the OFZ market has been inspired by expectations of key central bank rate increases in the short term,” VTB’s Podguzov said.

Bloomberg