Serhiy Yahnych of UkrSibbank -

Ukraine's domestic fixed-income market has been a "sleeping beauty" for several years. But after a period of blossoming, the girl under the glass is starting to stir and international investors have noticed just how attractive she is.

Last year was a watershed for the Ukrainian economy. Nominal GDP has already quadrupled since the beginning of the economic recovery and in February 2008 the country joined the WTO, giving it a good chance to hawk its competitive advantages of cheap labour and a favorable geographical position at the eastern border of EU. Ukraine has a number of strong developing domestic businesses, with growing demand for capital as major companies need to finance their rapid expansion and invest into modernization of existing facilities.

The domestic fixed-income market is still tiny compared to GDP - at the end of 2007, the volume of outstanding bonds amounted to only about $5bn, or 3.8%, of GDP - but it is growing fast. Primary market volume tripled in 2007 from the year before, even though the government's preferred financing remained via the international markets.

Financial institutions have taken the lead and offered a variety of debt - from first-tier banks owned by international heavyweights to smaller banks, issues which were interesting only to a limited number of domestic investors.

The international financial crisis provoked by the US mortgage market meltdown last summer had almost no impact on Ukraine's domestic liquidity - in August-October 2007, overnight rates were as low as 1%, reflecting the low presence of foreign speculative capital on the Ukrainian market

However, the turnover on the market continues to be low, with a major part of the turnover attributed to repurchase agreement, or repo, operations. Sluggish trading activity may be partly explained by cumbersome risk-management practices of the local banks (key investors in corporate bonds). On the flip side, Ukraine enjoys one of the lowest default ratios in the world, with zero default rates over the last two years.

High hryvna rates

Looking ahead, this year offers lucrative opportunities for the foreign investor. While interest rates on international markets are steadily declining, hryvna rates are up due to tighter monetary policy of the central bank, as like many other frontier markets Ukraine is facing a serious inflation problem. Growth in the headline CPI figure reached 19.4% year-on-year in January, and the policy of the central bank has become clearly hawkish, resulting in tighter lending conditions. Yields of the most liquid government bonds are up 1.5-2.0% from October when the rates were 6.0-6.5%, and corporate bonds are yielding 10-16%, depending on the issuer's quality.

The Ministry of Finance sees external borrowings as a major inflation driver and announced a shift of focus towards internal funding: the ministry plans to attract UAH7.8bn ($1.5bn) via the domestic market this year, twice what was raised on the domestic market in 2007.

In our view, the actual primary auctions volume will be even higher, as the public finances are stretched, with budget expenditure set to grow 46% this year. Moreover, the budget is likely to be amended as early as this spring to include more social initiatives. Large-scale privatizations will fund a portion of the fiscal deficit, but these privatizations are unlikely to start before the second half of 2008 because of lack of agreement between key political forces.

It is worth adding that the Ministry of Finance has already begun preparing the ground for more issues of bonds this year and a detailed primary auction schedule, with the obligation to borrow at least UAH300m each month domestically and an intention to tap each series of government bonds until its size is UAH1bn or above.

Some of the quasi-sovereign companies may also tap the primary market this year. An incomplete list of these potential issuers would include the State Mortgage Institution (SMI), Ukrainian Railroads and Ukravtodor. SMI is to offer UAH1bn ($200m) worth of bonds guaranteed by the state and plans a debut issue of mortgage-backed bonds.

The supply of municipal bonds is also set to increase, mainly driven by a heavy need in infrastructure improvement before the 2012 European football championships, which Ukraine will co-host with Poland. The city of Lviv has already announced a UAH200m ($40m) bond issue, while several other cities have similar issues in the pipeline.

Financial institutions are to offer at least UAH10bn-15bn ($2bn-3bn) worth of bonds on the local primary market. Recently the central bank introduced mandatory reserves for syndicated loans and Eurobonds, and in a separate action made it difficult for the banks to excessively rely on retail deposits (a key funding source for Ukrainian banks) to comply with regulations.

The majority of issuers in the corporate non-banking sector have yet to reach the size and degree of transparency acceptable for international investors. Industrial holdings (such as steel and pipes), infrastructure-related companies, agribusiness and selected retailers are to constitute a core of the primary market issuers.

For now, we see no good reason for a drastic improvement in secondary market activity and it will probably take several years for it to improve. Fortunately, a vast majority of local bonds typically have annual put options, which decrease the liquidity risk. Also, the currency tax (applied to all purchases of foreign currency) was halved in 2008 to 0.5% and might be fully abolished in 2008-2009.

Serhiy Yahnych is Head of Fixed Income Research at UkrSibbank BNP Paribas Group

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