ANALYSIS-Russia's treasury bonds to test "Big Bang" theory
* International settlement due in early 2013
* Reform could lower 10-yr yields by 85 bps - BarCap
* Investors eye fiscal, oil, inflation risks
MOSCOW, Dec 3 (Reuters) - The prospect of "Big Bang" reforms to liberalise Russia's $100 billion local treasury bond market has driven yields to record lows, and the rally could run further as the debt becomes available to a wider pool of international buyers.
The long-awaited upgrade to clearance and settlement rules, due to be completed early next year, has attracted early movers: foreign ownership of Russian treasuries has more than doubled this year to 9 percent of the total, Barclays Capital estimates.
That has driven a rally of 13 percent in the year to date in Russian government bond prices, according to the MICEX RGBI Total Return Index.
Bulls see room for the rally to extend, as foreign ownership of rouble-denominated government bonds still lags the average share in emerging markets of 27 percent, Russia offers a yield pickup to its peers and has low sovereign debts.
The higher yields stem largely from a lack of access for outsiders which has held back market liquidity, but also reflect Russia's reputation for political risk, corruption and legal uncertainty, which remains a turn-off for many investors.
"Russian yields are attractive, they offer some of the higher yields available in emerging market local debt," said Michael Mon, a portfolio manager at AllianceBernstein who sees foreign purchases of $10-$20 billion over the next three years - around 3-5 times more than inflows seen this year.
While some of this money would be transferred from existing investments in internationally-traded Russian bonds, the liberalisation is also expected to draw new investment from funds attracted by the higher returns on local debt.
The upgrade to the market's infrastructure will make local-currency debt accessible to large foreign funds with strict compliance rules that now restrict their exposure to Russia's lower-yielding dollar- and rouble-denominated Eurobonds.
But even after Russia clears the regulatory hurdles, some investors say it will need to prove its commitment to fiscal prudence and lower inflation to see a sustained decline in benchmark yields, which, at around 7 percent, are just above inflation.
"For investors to take a higher-conviction view, to be significantly overweight, we need to see the results of the new policy measures that have taken place," said Saad Siddiqui, EMEA fixed income strategist at Credit Suisse.
The essence of the reform is that Euroclear, the largest international settlement system for bonds, will soon be able to settle trades for locally-issued treasury bonds, known as OFZs.
That required an overhaul of outdated infrastructure and regulation and enables more conservative international investors with deep pockets - pension funds, sovereign wealth funds and central banks - to buy OFZs.
Euroclear is expected to start offering services in late December or January, after the commissioning of a new central securities depository in Moscow i n November paved the way for international clearing houses to open nominee accounts.
"We have exposure to Russian local debt but will likely wait for euroclearability before potentially adding more," said Andrew Keirle, a fund manager at T.Rowe Price.
The market has already seen an inrush from less conservative investors. So far this year, the OFZ market has seen a direct inflow from abroad of at least $3-$4 billion, with a further $5-$7 billion in from hedge funds via derivatives that provide indirect exposure, estimates Credit Suisse.
"We are forecasting 85 basis points of yield compression over the next one year on 10-year paper, a very aggressive call," said Koon Chow, a strategist at Barclays Capital, forecasting that by 2014 the market will attract an additional $25 billion to $40 billion in foreign investment.
Despite the compression in yields, benchmark OFZs still look appealing compared with many other emerging market bonds, where yields have fallen further. Bond prices rise as yields fall.
The yield on the 10-year OFZ has declined by 150 basis points this year to just below 7 percent, while Turkey's 10-year bonds now yield around 6.7 percent - in line with South Africa.
OFZs have benefited as investors switch out of lower-yielding Russian bonds issued internationally - sovereign eurobonds, quasi-sovereign issues of large state-controlled firms and corporate eurobonds.
STRONG BALANCE SHEET
A further draw for investors is Russia's strong balance sheet, with sovereign debt at just 10 percent of gross domestic product (GDP). The Finance Ministry plans to cap annual issuance of OFZs at 1 trillion roubles ($32 billion).
Russia has also recently established new fiscal rules which tie spending plans to the long-run average oil price over previous years, and cap government borrowing at no more than one percent of gross domestic product.
But the world's largest oil exporter remains vulnerable to lower international energy prices. And it faces tough decisions to balance the federal budget after President Vladimir Putin boosted spending dramatically to smooth his re-election to the Kremlin in March.
Russia is expected to run a small budget surplus this year and has cut its borrowing plans several times this year, as oil prices top the government's forecast of $109 per barrel <URL-E>.
However, in future Russia's federal budget will only balance if oil prices hold above $104 per barrel until at least 2015. That figure would rise to $119.5 by 2020, according to a recent Finance Ministry projection.
A MATTER OF YIELDS
A further concern is that inflation, which hit a record low of 3.6 percent in April, has risen steeply in recent months, reducing the real returns on rouble investments.
"Inflation in Russia will reach 7 percent and that suggests a decline in real positive interest rates ... and that offers a limited potential for the price growth after the liberalisation," analysts at Raiffeisenbank wrote in a note.
High demand for OFZs from abroad could soon result in negative real returns for Russia-based investors, creating a possibility for a pullback.
But the prospect of larger foreign inflows into the bond market could also be positive for the rouble, adding to the appeal of OFZs for non-resident investors.
Barclays forecasts that the rouble will firm versus the dollar by 3 percent to 30.0 over the next 12 months .
"There is potential for international flows," said Luis Costa, emerging markets strategist at Citi. "There will probably be a gradual shift (into OFZs). It's a curve that makes sense, there are pretty high nominal yields at the long end." ($1 = 31.0490 Russian roubles)
(Additional reporting by Carolyn Cohn and Sujata Rao in London; editing by Jason Bush, Douglas Busvine and Philippa Fletcher)