Betting on high yield debt in CEE

Betting on high yield debt in CEE
By Ben Aris in Berlin and Nicholas Watson in Prague January 30, 2017

It all happened very fast. On November 1, bne IntelliNews ran an expose, “Privat investigations: PrivatBank lending practices threaten Ukraine’s financial stability“, which described how an extensive web of shell companies was being used by PrivatBank’s owners to bleed Ukraine’s largest commercial bank dry. Just six weeks later, on December 18, the National Bank of Ukraine (NBU) announced the bank would be nationalised and within a week holders of the bank’s $600mn worth of Eurobonds had been wiped out. Together with Ukraine’s hard-pressed taxpayers, who will likely end up carrying the can for the proposed $4.4bn rescue, bondholders were the big losers from the nationalisation, as depositors are protected by a law that had been changed a year earlier to unusually guarantee 100% of retail deposits.

Global fixed-income investors have been driven to Ukraine and elsewhere in Central and Eastern Europe/Commonwealth of Independent States (CEE/CIS) by the lack of returns in the developed markets, but PrivatBank’s nationalisation shows just how risky investing in this part of the world can be. The sanctions on Russia for its annexation of Crimea and the war in Ukraine’s east has sent many issuers in the region scrambling to restructure their debts that were issued during happier times. “We indeed have seen an increase of distressed debt and restructurings since the 2008 financial crisis. The situation somewhat varies between countries and sectors, but overall we have seen an increase in those types of activities,” says Miroslav Dubovsky, managing partner for DLA Piper in the Czech Republic.

Yet there have been some positive developments for investors in distressed debt – those securities that carry a ‘CCC’ or below rating or have a spread of more than 1,000 basis points over a standard risk-free instrument – in the years since 2008. Positive changes to domestic laws in CEE/CIS governing debt restructuring, the development of local distressed debt markets, as well as an upsurge in the use of English law schemes of arrangement in cross-border debt restructurings have combined to open up new opportunities. “The major changes were in insolvency and bankruptcy legislation and also in relation to regulation,” says Dubovsky. “In many jurisdictions the distressed debt markets are dominated by local players, but we see increased interest and involvement of international players in CEE [and] we do believe that this trend will continue.”

“We believe that the macroeconomic trends will continue to drive the restructurings in CEE are therefore quite positive about the outlook for the next year,” he adds.

On the edge in Ukraine

Unlike Ukraine’s sovereign debt restructuring deal agreed by former finance minister Natalie Jaresko in 2014 that included a 20% haircut and extending maturities by several years, there was no attempt to even contact the PrivatBank bondholders before the bank’s nationalisation in December. Normally, bondholders are at the top of the list of creditors to be repaid when a company goes belly up, but under the terms of a banking law that Ukraine passed in 2015, a strategically important bank can have its bonds “bailed-in” by the NBU.

At his first press conference on December 22, PrivatBank’s newly appointed CEO, Oleksandr Shlapak, confirmed that all the bank’s Eurobonds were converted into equity as part of a bail-in. “Together with the National Bank, we will try to find common ground with the Eurobond holders. If not, then we will prove our case in court,” he told reporters.

PrivatBank was nationalised according to Article 41.1 of the Deposit Guarantee System Law. The Eurobonds were issued by a UK-based special purpose vehicle (SPV) affiliated with PrivatBank, and the law paves the way for a bail-in of all related-party deposits and unencumbered non-deposit liabilities (including loans from the SPV financed by the Eurobonds) into equity.

Part of the reason that the bondholders got such harsh treatment, believe some, is that the bank owners, Ukrainian oligarchs Ihor Kolomoisky and Henadiy Boholyubov, who oversaw billions of dollars of depositors’ money funnelled through Alpine banks into offshore entities, are believed to hold a large part of PrivatBank’s Eurobond and the majority of the subordinated credit. PrivatBank issued two senior Eurobonds, the first worth UAH160mn that matures in January 2018, and the second worth UAH175mn that matures in February 2018. In addition, it issued subordinated Eurobonds maturing in February 2021 that were issued in two tranches of $150mn issued in 2010 and restructured in 2015, and an additional $70mn issued in 2015 and purchased by related parties.

“If the government had to honour these bonds, it would probably cost another $200mn-300mn and that is probably not acceptable to the government,” says Mykhaylo Demkiv, a financial analyst at Investment Capital Ukraine (ICU) in Kyiv. “You would have thought the regulator is a bit allergic to bailing out the same oligarch to the tune of hundreds of millions of dollars that pushed the bank into liquidation.”

While Ukraine’s finance ministry insists it is confident the new law justifies its decision, other members of the government are not so sure and there’s a good chance the bondholders will sue, warn bankers in Kyiv. Indeed, recent comments from government officials that bondholders might receive some sort of compensation suggest the ministry is getting cold feet; Ukraine will have to go back to the bond markets soon and is worried about its reputation.

Kolomoisky has been given six months to come up with some collateral that the related-party shell companies were supposed to put up against their loans, so PrivatBank should be able to recoup some of the billions that disappeared out of the door. “If he does nothing, then the NBU has said that includes a criminal procedure after six months, as owners can be held criminally liable for misconduct,” says Demkiv. “But jailing him would be difficult and not useful from a political point of view.”

Clearly, some investors believe a deal might be possible – but not many. The bonds are currently trading at about 10% of their face value.

Kolomoisky is such a big figure in Ukraine that he can cut deals at the highest political levels for special treatment. But the rest of Ukraine’s high yield issuers have had to work at a commercial level and cut amicable deals with investors. Ukraine’s corporate bond market is worth about $10bn – a big enough market to interest international investors – but many of the borrowers that have issued sizeable amounts of debt got into trouble in 2015 when the economy collapsed.

Fortunately, Ukraine has taken some steps to bring some order to its corporate restructuring laws, which –  though still far from perfect – are already starting to bear fruit.

The latest came on October 19 when the long-awaited Law of Ukraine “On Financial Restructuring” came into force, which introduced an out-of-court procedure for the restructuring of liabilities of Ukrainian debtors other than banks or other financial institutions. This was drafted as a policy response to address the problem of non-performing corporate loans on the balance sheets of Ukrainian banks, as well as rectify the historically low rate of creditor recoveries in Ukrainian insolvency proceedings compared to other jurisdictions.

“Although the Restructuring Law has been criticised for being somewhat limited in the scope of its application, there are two key features about the law that are worth highlighting. First, the Restructuring Law allows the debtor company to include in the process not only credits of commercial creditors, but also the credits owed to state-owned banks as well as the Ukrainian tax and other state authorities. Second, Ukrainian debtors may also benefit from the tax incentives set out under the Law of Ukraine ‘On Amendments to the Tax Code of Ukraine and Other Laws of Ukraine On Ensuring Balance of Budget Revenues in 2016’, dated December 24, 2015, which applies exclusively to restructurings under the Restructuring Law,” explains Andriy Nikiforov, head of restructuring and insolvency at Kinstellar’s Kyiv office, who worked on the debt restructuring of Metinvest.

Restructuring deals like that of Ukraine’s national rail company Ukrzaliznytsia have been well received by investors and its bonds are now trading at yields below those of the sovereign debt.

In December, Ukrzaliznytsia persuaded 93% of its bondholders to sign off on a cross-default waiver until 2018. In September, the company had failed to agree a restructuring deal with local banks on $242.5mn of debt that could have caused an acceleration of claims on the company’s bonds worth $500mn due in May 2018. Restructuring of the company’s debt to local banks began in February 2016, but so far the company has only managed to restructure 39% of its $918mn in total debt, while the debt of the Donetska Railway subsidiary, worth $64.9mn, won’t be restructured until the company regains access to its assets on the territories of the Donbas region that are occupied by pro-Russian rebels and Russian troops.

With the December 7 vote, Ukrzaliznytsia’s bondholders agreed to carve out this debt from the scope of the cross-default provisions. The bondholders will receive 0.5% consent fee for agreeing to the waiver, but the company has yet to report on a payment date. “Approval of the cross-default waiver is a logical event that enables most bondholders to gain an additional fee from the company. We do not rule out that the company will ask for another waiver in one year, given that talks with local banks are going slowly. Our neutral/skeptical view of [the railway company] bonds remains, given the company’s high capex appetite that exceeds its ability to generate cash from its operations,” says Alexander Paraschiy, head of research at Concorde Capital.

Many of the country’s largest corporations – the utility DTEK, metal giant Metinvest and JKX Oil & Gas – have also been forced to restructure their bonds, with many deals closed as 2016 came to an end and 2017 began. “The restructuring process has nearly run its course. DTEK was restructured in 2016 and Metinvest was finished [in the first days of January]. After DTEK was restructured, there was a two-way flow of investment. There was some profit-taking, but it was not massive. Mostly, it was buyers of the bonds and the prices have now stabilised,” says Mauro Della Cioppa, the partner at BCP Securities responsible for fixed-income trading of Russia, the CIS and Turkey.

The restructuring of UK-registered JKX Oil & Gas went more smoothly. With assets in Ukraine and Russia, bondholders agreed to postpone the maturity of $16mn in bonds from February 2017 by four years, the company said in a statement on January 3. A total of 88.75% of bondholders voted in favour of the restructuring and JKX will increase coupon payments to 14% from 8% previously. The notes will now be repaid in three equal annual instalments starting February 2018. In February 2017, the company will pay $2.6mn in scheduled interest and accretion payments. “The development is positive for JKX, as it will save critical liquidity and enable it to execute its capex programme,” Concorde’s Paraschiy said on January 4. At the same time, investors are waiting for the outcome of an ongoing international arbitration over demands from JKX for more than $180mn in compensation from the Ukrainian government for overpaid taxes.

The restructuring of the debt of Ukraine’s largest steelmaker and iron ore miner Metinvest took a little longer and is still not complete. The company published the final restructuring terms of its Eurobonds on December 23 and won preliminary approval from half of the bondholders. A final decision will be made after a UK court ruling on the deal, slated for January. The holding’s three Eurobond issues – maturing in 2016, 2017 and 2018 – will be reorganized into a single note maturing on November 18, 2021. The new bonds will pay a 10.875% coupon in cash quarterly starting November 18, 2018. Before that, they will pay coupons in cash and payment-in-kind (PIK), including: a minimum 2.793% cash coupon; a PIK coupon of 6.5795% (paid in cash or capitalized to be repaid as soon as possible); and a “catch-up” coupon of 1.5025% (paid in cash, otherwise not capitalized). All the amounts that exceed cash coupons are only payable if unrestricted cash amounts at Metinvest accounts exceed $180mn. The first coupon will be paid on May 18, 2017. A restructuring fee of 0.75% will be payable to all creditors on the date of the restructuring, and an additional 0.75% fee will be payable to creditors who join the “lock-up agreement” by January 16, 2017.

The restructuring of the debt of DTEK, the largest energy company in Ukraine owned by billionaire Rinat Akhmetov, saw the conversion of $160mn of Eurobonds maturing in March 2018 and $750mn maturing in April 2018 into a single issue that matures in December 2024. The company also successfully completed a tender to convert up to $300mn in bank loans into new Eurobonds. “We see a fair spread of new Eurobonds to Ukraine’s sovereign curve at about 400 [basis points], which implies a bond price of 89% of par,” says Paraschiy of Concorde.

The restructuring of DTEK’s Eurobonds was approved by 88.96% of the holders on December 19 and was sanctioned by the High Court of England and Wales on December 21. The new notes have a 10.75% coupon rate, with the coupons payable quarterly in cash and PIK. The minimum cash amount to be paid will be: 5.5% in 2017 and 2018, 6.5% in 2019, 7.5% in 2020, 8.5% in 2021, 9.5% in 2022 and 2023, and 10.75% in 2024. The unpaid amount will be capitalized quarterly, paying interest, the company said. DTEK is planning to repay 50% of the bonds outstanding (including the capitalized amount) on December 29, 2023, and the rest on December 31, 2024. Shortly after the deal was first announced, the bonds traded at about 81.3% of par, the highest levels since July 2014, and still look attractive, according to Concorde.

Putting some English on it

The DTEK restructuring is part of an upsurge in the use of English law schemes of arrangement in cross-border debt restructurings by businesses located in Russia and its neighbours. “The scheme’s key advantage is that it can provide companies with a way to implement a restructuring solution at a lower approval threshold than may otherwise apply pursuant to the terms of the underlying debt documents,” Polina Lyadnova, a partner at Cleary Gottlieb Steen & Hamilton, and her colleague Sui-Jim Ho, explained in an article published in her law firm’s most recent Emerging Markets Restructuring Journal. “Coupled with the English court’s increasing willingness to sanction schemes for foreign companies, it is no surprise that schemes are emerging as the favoured tool of choice for those engaged in complex cross-border restructurings.”

What was notable in the DTEK case was that the restructuring involved what were originally New York law-governed high yield bonds being changed to those governed by English law. “In the DTEK case the judge confirmed that, despite DTEK moving its [centre of main interests] to England as a prudential measure, the fact that the notes are now governed by English law is alone sufficient to fulfil the ‘sufficient connection’ test in order to confer on the English court jurisdiction to approve the scheme,” Lyadnova and Ho noted.

The largest-ever scheme of arrangement proposed by a company with its main operations in Russia and the CIS was that from Rusal, one of the world’s largest aluminium producers, which in 2014 restructured its $4.75bn and $400mn aluminium pre-export finance (PFX) term facilities by proposing parallel schemes of arrangement in England and Jersey. This was an “amend and extend” scheme, whereby the principal amounts payable remained unchanged, with the main purposes of the restructuring to revise the amortisation schedules, to defer the final maturity dates and to reset the financial covenants under the PFX facilities.

“The existence of certain dissenting creditors meant that the group was unable to pass the relevant proposal using the contractual route, which required all lenders’ consent,” wrote Lyadnova and Ho. “Rusal therefore proposed parallel and inter-conditional schemes of arrangement in England (being the governing law of the PXF facilities) and Jersey (being the jurisdiction of incorporation of Rusal), which would only require the approval of a majority in number holding 75% by value of the lenders.”

“The English law scheme of arrangement has come of age and is now a credible weapon in the restructuring armoury,” argued Lyadnova and Ho. “Given the English court’s increasing readiness to accept jurisdiction and their pragmatism in sanctioning arrangements approved by the statutory majority of creditors, a scheme may offer a solution where none is in sight.”

Russia, unsurprisingly given the geopolitical situation and the relatively large size of its corporate bond market, was a centre of debt restructuring in the region. In fact, at one point in January 2015 Bloomberg data showed that one in every five distressed corporate bonds worldwide were from Russian issuers as Western sanctions and the associated economic crisis began to bite. This, however, proved to be the bottom of the market, and a bout of debt restructuring coupled with a turnaround in the economy has transformed the market. “In Russia the real trouble stated in February 2014 and lasted a year, but by the same time in 2015 the prices had recovered to their previous price and have even moved higher since then,” says BCP Securities’ Della Cioppa.

Societe Generale in Moscow said in an analyst note on January 19 that in two years Russia has gone from being a feared and largely avoided jurisdiction (end-2014), to an all-time favourite (end-2016). “The country is benefiting from a combination of improving macro fundamentals, credible monetary and financial authorities, and what is perceived as manageable political risks, making it the sweet spot in the EM universe. This already has been largely reflected in the valuations of Russian assets with the ruble acting as one of the best EM FX performers both in 2016 and early 2017, while the Russian local debt yields are breaching the 3-year lows under pressure from international buyers,” it said.

A good example is Mechel, the miner and steel producer that was once regarded as a poster boy for the “new Russia” when it debuted on the New York Stock Exchange in 2004, but which borrowed too heavily in the lead-up to Russia’s economic crisis to fuel an acquisition binge and ended up being unable to keep up repayments as demand for its products collapsed along with prices for coal.

After two years of tense negotiations, during which its very survival was cast into serious doubt, Mechel now says it expects to sign a final debt-restructuring deal on the $9.6bn of debt in early 2017, following a final agreement reached in December with the Russian state-owned banks that hold 67% of Mechel’s debt. The biggest part of Mechel’s outstanding debt that has yet to be restructured is owed to two groups of creditors: $500mn to export credit agencies and $1bn to a syndicate of international banks.

The news of the restructuring, together with the spike in global coking coal prices, has helped pull Mechel’s bonds out of the distressed category they found themselves in in February 2016, to the point where they are now trading at about 85% of par, according to Cbonds, a financial news agency and data vendor on global capital markets operating in Russia and Ukraine.

Ukraine and Russia are certainly not out of the woods – and indeed are arguing in the High Court in London over a $3bn bond Russia issued on which Kyiv defaulted in 2015 – but the debt restructuring story in both countries over the last two years has shown that being distressed is not a death sentence any more.