Andriy Dmytrenko of Dragon Capital -

With Ukrainian equities battered and unlikely to start recovering at least until the second half of 2009, fixed-income instruments have become a viable alternative to maintain exposure to Ukraine. Despite the widespread speculation about a looming Ukraine default, we think the prospects aren't as bleak as some suggest. Selected bond issues are definitely a lucrative opportunity to consider for risk-tolerant investors, with some lower-risk bond prices already up substantially on recovering demand.

Sovereign issues

Yields on Ukrainian sovereign Eurobonds surged as high as 70% by the end of 2008 from 30-50% in October and 8.0-9.5% in June, trailing only Ecuador's defaulted bonds, as investors remained concerned about the country's economic performance and ability to service its debts in a tight global credit environment. The EMBI+ Ukraine spread rose nine-fold during the year to 2,735 basis points (bps). Five-year credit default swaps on Ukrainian debt widened to over 3,400 bps, trading above Venezuela and Argentina swaps.

Compared with other bonds of similar risk, Ukrainian sovereign debt was priced 600-2,000 bps higher as of mid-February. We consider investors' perception of Ukraine's default risk exaggerated and see no reasons for Ukrainian bonds to be so heavily oversold.

While we estimate Ukraine's total foreign debt obligations falling due in 2009 at $46bn, government debt accounts for a mere $1.6bn of this amount. The latter includes a $500m publicly traded Eurobond paying a coupon of 6-month Libor plus 3.75% and maturing in August 2009 (the bond was priced at a 28% discount to par, implying a 90% yield on February 13).

The state budget law for 2009 allows the government to borrow $700m externally this year to finance the budget deficit and repay debts. We do not expect Ukraine to be able to raise this much debt in the current credit environment, but think the government can borrow sufficiently from multilateral lenders. The international borrowing expected in 2009 includes close to $9.7bn from the IMF (out of the $16.4bn two-year standby loan approved last October) and $1.2bn from the World Bank. In addition, the government has confirmed recently it was seeking to borrow $5bn in bilateral sovereign loans to finance the budget deficit. Ukraine's public debt stood at $24.1bn as of end-2008, equalling 19.8% of GDP or well below the internationally recognized safety threshold of 60%.

Corporate issues

Ukrainian corporate bond yields followed their sovereign peers on the way up in 2008, soaring to 160-180%, among the highest corporate yields globally, and widening their spreads by 6,000 bps and more. Banks' Eurobonds predictably showed the largest spread widening (up to 14,000 bps), reflecting the global deterioration of investor sentiment towards the financial sector.

Domestic companies and banks will need to redeem $2.1bn of maturing or "putable" bonds this year. Most issuers, especially foreign-owned banks, should not encounter critical problems repaying their foreign liabilities. In the first positive sign, state-owned rocket manufacturer Yuzhmash has redeemed a $107.5m five-year Eurobond that matured on February 2. The Ukrainian Finance Ministry financed the redemption, concluding a debt-restructuring agreement with the company. This especially bodes well for other Ukrainian quasi-sovereign issuers, signalling the government remains committed to repaying debt obligations guaranteed by the state.

We do not rule out a few heavily indebted or low-cash companies defaulting on their obligations this year (eg. property developer XXI Century and a few troubled banks), but we by no means expect an avalanche of Ukrainian bond defaults as their current yields may suggest. Our top picks in the corporate bond sector include debt issued by the state-owned Ukreximbank as well as by foreign-owned commercial banks (Forum Bank 2009, Ukrsotsbank 2010, Ukrsibbank 2010). Forum Bank's Eurobond maturing in October 2009 has risen to $78 from $69 in price since last November, supposedly boosted by demand from Forum's parent, Commerzbank, which started to pick up the hugely oversold debt. Among non-financial sector issuers we recommend steelmaker Azovstal, part of the vertically integrated group Metinvest.

Potential strong demand for Ukrainian Eurobonds may also come from local buyers as soon as legal obstacles preventing domestic investors from trading in Eurobonds are lifted. As Russia's experience shows, this may turn into a powerful force. Russian investors became increasingly active on the market for Russian Eurobonds last November, buying debt at deeply discounted prices to hedge themselves against further ruble depreciation. Their activity provided for a sharp rebound in bond prices (see table).

Andriy Dmytrenko is Chief Strategist at Dragon Capital

Send comments to The Editor