Jathan Tucker of Galt & Taggart Securities -
For over a month, market players have been riding a wave of buying pressure in Eastern European credits, completely re-pricing the region's credit. Nowhere has the move been more pronounced than Ukraine.
The month of March opened with a massively inverted yield curve on the sovereign, indicative of a market under extreme stress. The August floater was quoted with yields as high as 100% and credit default swap (CDS) protection had to be purchased with up-front cash payments to major dealers. Now, sentiment en masse seems to have turned entirely the other way, with the sovereign curve steepening and pulling quasi-sovereign and corporate names with it. Front-end yields have more than halved and some issues have provided an absolute return of more than 100% over just a six-week period.
As we started the spring, the entire country was essentially priced as a distressed asset, offering value significant enough to attract the more risk tolerant investors into selected names. However, the broad-based rally that followed took on a life of its own, prices regularly gapping wider and offers vanishing - but ultimately lost sight of the macroeconomic picture, which did not change in a serious way from the start of the move until now.
The first risk comes from the inability of companies to source dollar cash to make payments on their bonds. It is unlikely that funding markets will allow new dollar financing for corporates, unless from foreign parents. The country's main export, steel, remains weak and will not be able to fill the financial system's requirements for foreign currency – which leaves only the currency reserves of the central bank (NBU). Funds from the IMF dramatically reduce the risk to the sovereign payment schedule, but first in line for those funds will be repayments by the government, followed by securing gas supplies and defending the hyvnia. There is a very real risk that corporates this year will be unable to purchase dollars in an interbank market where liquidity is squeezed out by the NBU to maintain a certain hryvnia level. Banks are able to play by the rules of the NBU in the short term, but ultimately this pent-up demand for foreign currency to meet obligations will come into the market. In a market where there is only one likely supplier, it will force the NBU to choose from three unattractive options: to use their foreign exchange reserves to defend the currency and fill forex demand in the market from the corporate sector; allow the hryvnia to weaken; or run the risk of corporates defaulting from lack of currency.
Secondly, the deteriorating balance sheets of the corporate sector have not fundamentally changed during this time either. The dollar-cash demand that will likely force the hryvnia weaker, will weigh heavily on the banking system, pushing non-performing loans higher and further eroding their capital bases. The consensus view of a climb in non-performing loans due to deteriorating GDP has not improved despite the run up in the banks' Eurobond prices. Recapitalization provides some level of support for the bondholders, but prices continued to rally even when Ukraine's president himself makes comments on corporates investigating debt restructurings.
The disconnect between risk pricing and where Ukrainian Eurobond curves now trade has been largely based in the momentum of its own rally, and chasing down better performance in Russia. But the fundamentals have not changed yet and the most difficult point for the economy will come later in the year, as financing payments come due and corporate defaults mount.
Yields as we entered March were at eye-popping levels and provided some of the best buying opportunities in the market on a risk/reward basis. But the wave of buying, much of it locally driven, has pushed pricing back to levels where its best to carefully consider if this is a rally worth selling into, before corporate defaults shock the market.
Jathan Tucker is Head of Sales and Trading at Galt & Taggart Securities
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