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 Fund managers, among whom Templeton's Michael Hasenstab is
prominent, have until now figured that Ukraine would avert all-out
war with Russia, allowing its economy to recover. Second, they have
reckoned the International Monetary Fund, which has pledged a $17
billion loan deal, has Ukraine's back.
For these reasons Ukrainian bonds have traded not far off their
launch prices, levels many analysts consider astonishing given the
level of economic distress the country is suffering.
But recent days have shattered investors' faith, as Russian troop
moves have effectively ruled out any speedy peace deal or economic
rebound. Analysts predict Ukraine's economy may contract by up to 8
percent in 2014 and by 5 percent in 2015.
And crucially, IMF comments last week are being interpreted by some
as bringing Ukraine closer to debt restructuring.
The fund released more cash but said that if Ukraine's situation
worsened, "the program would need to be significantly recalibrated,
including potentially the financing".
"There's two ways you can read last week's IMF statement on Ukraine.
One is, don't worry there is more money coming. Or second, there is
more money coming but you guys (investors) will need to contribute,"
said Gabriel Sterne, head of global macro at consultancy Oxford
Economics.
He was referring to "bail-ins" that force private sector creditors
to bear some of the rescue burden by restructuring debt or
reprofiling it by extending debt maturities. With little debt this
year, many see the latter option as more likely.
For a TABLE on maturing Eurobonds click
IMF programs by themselves don't exclude default, Sterne notes,
citing Greece which was on a fund lifeline for two years before
forcing investors to take a 70 percent debt write-down.
Possibly chastised by the Greek experience, a 2013 IMF paper said
future restructurings should be timely, without "allowing an
unsustainable debt situation to fester". It also wants to stop using
its resources "to simply bail out private creditors."
For sure, Kiev has a far lower debt ratio than Greece at just half
its annual economic output (GDP). And the West, locked in a
political standoff with Russia, is unlikely to let Ukraine sink. But
lenders may want to rope in private creditors if they find
themselves increasing the size of the aid.
"Ukraine need a bigger program, and reading between the lines, they
haven't decided whether they need to reprofile or not. I think the
temptation will be to reprofile," Sterne said.
Bond prices fell 8-12 cents on the dollar over August, and the cost
of insuring exposure to Ukraine via credit default swaps has risen
steadily. One-year CDS now cost more than 5-year swaps, data from
Markit shows, a sign of short-term debt stress.
JPMorgan advised clients to cut Ukraine holdings. It doesn't see a
crash on the bonds as imminent, but says the "likelihood of eventual
restructuring in 2015 has increased significantly".
OVER-OPTIMISTIC
Original economic recovery assumptions for Ukraine have turned out
way too optimistic. As recently as end-2013, the IMF had assumed a 1
percent growth rate for this year.
But the economy shrank 4.7 percent in the second quarter compared
with the same year-ago period while industrial output plummeted 12
percent in July. Tax revenues from the heavily industrialized
eastern provinces have fallen, even as Kiev is forced to up military
spending.
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In July, President Petro Poroshenko estimated Ukraine was spending
$6 million a day on the conflict, but this will have risen since
then, as fighting has intensified.
The hryvnia currency, meanwhile, is approaching the 14 per dollar
mark - at the start of the year it traded at 8.
The relentlessly depreciating currency is shrinking domestic GDP in
dollar terms while making it costlier to service debt, 70 percent of
which is in hard currency, says Steve Ellis, a fund manager at
Fidelity, calling it "a vicious downward spiral."
"We know Ukraine is strategic but the IMF don't disburse money in a
deteriorating situation and when you see debt-GDP going above 60
percent, the IMF will be running just to stand still," Ellis said.
"Bond prices have not deteriorated because investors always believed
there will be an official backstop but the reality is this backstop
will probably not be sufficient."
Debt ratios are 45 percent of GDP, versus 36 percent in 2012. The
IMF's baseline forecast was for the 60-percent mark to be hit in
2018 but many now expect it by 2015, enabling Russia to demand
immediate payment on a $3 billion bond it holds.
But because ratios are still fairly low, the Fund may prefer a debt
reprofiling to restructuring - extending the time for repayment but
without marking down the value of the debt. Extending the 2017 bond,
for instance, to 2020, would change the profile of the yield curve
and give Kiev more time to pay.
HASENSTAB PUT, HIGH YIELDS
Surveys suggest investors are underweight Ukraine, meaning average
holdings are less than its weight in bond indexes. But its high
yields - yield premia to U.S. Treasuries are more than triple the
emerging markets average - have kept many hanging on.
Also of comfort to investors is the presence among their ranks of
Hasenstab, the Templeton fund manager who has made his name with
contrarian - and ultimately lucrative - bets such as Hungary. At
last count, Templeton held almost a third of Ukraine's outstanding
sovereign Eurobonds across its funds.
Angus Halkett, a fund manager at Stone Harbor Investments, says he
is no fan of Ukraine but finds it hard to avoid the high-yielding
asset. Then there is the Templeton factor.
"(Templeton's) presence absolutely makes a difference to everyone,
the price of our position essentially depends on them, they are
pricemakers," Halkett added.
Hasenstab argued in a June interview with Morningstar that Ukraine
faced a liquidity, rather than solvency, problem and Western aid
would help it overcome that. He said he was looking past short-term
volatility into a three- to five-year horizon.
If debt reprofiling allows Ukraine to sort out its finances,
Hasenstab may yet come out on top, as it would enable investors like
him to clip 8-9 percent coupons for a few years more.
(Additional reporting by Carolyn Cohn in London; Editing by Giles
Elgood)
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