Alexander Valchyshen of ING in Kyiv -

For the most part of 2006, interest rates for Ukrainian bonds were relatively stable as the benchmark government bond maturing in December 2009 saw its yield climbing during the first quarter of 2006 from the 8.25-8.5% range to the territory of 10.0-10.5%, and staying there nearly until the end of the year though retreating toward 9.5% recently. The rest of the traded government bond market universe (with shorter maturities) followed suit contracting 50-100bp in yield, resulting in a relatively flat yield curve with interest rates along the maturities in the range of 9.0-10.0%.

Market size

Despite a reshuffle of the Cabinet of Ministers in August 2006, the MoF's approach to local borrowings has remained rather sceptical in terms of the capacity of the local bond market to cover all the financing needs of the government and especially in terms of the interest rate level, which is higher than for borrowings from abroad. In search of low yields, the MoF has issued debt in US dollars, Swiss francs and Japanese yen while a small portion of financing was left to be funded in the local currency (UAH1.6bn or 14.3% of total funds borrowed in 2006). In net terms, during 2006 the MoF redeemed more than it borrowed from the market, further lowering the volume of government debt by UAH2.6bn or 13.4% from UAH19.2bn as at 31 December 2005 to UAH16.6bn as at 31 December 2006. In relative terms, public debt now stands at 3.2% of GDP.

In other segments of the domestic bond market, municipal bonds remained scarce at 0.1% of GDP, with UAH553.5m outstanding as at the end of 2006. However, the corporate segment appears to be in far better shape as private companies and banks are tapping the market on a regular basis. Corporate bond market size rose from UAH4.4bn as at 31 December 2005 to UAH6.8bn as at 31 December 2006. In relative terms, this segment accounts for 1.3% of GDP.

Government sector

From September 2006 till the end of the year, the MoF carried out a series of regular government bond auctions raising UAH1.6bn ($0.32bn) locally by placing two-, three- and five-year bonds. However, the outstanding amount of tradable government bonds shrank sizably by 23.2% from UAH10.0bn ($1.98bn) as at 31 December 2005 to UAH7.7bn ($1.52bn) as at 31 December 2006 as the MoF met its obligations on paying out interest and principal on short-term bonds with maturities of one and one and a half years. These bonds' total outstanding was approximately UAH3.0bn ($0.6bn) at the very beginning of 2006.

The limited availability of government bonds circulating on the market prevented prices from sliding further during 1H06 when foreign investors unloaded these papers from their portfolios on the back of the political uncertainty associated with the drawn out talks on forming a parliamentary coalition.

Later on, market conditions improved as the new government entered office enjoying firm support of the parliamentary coalition. Government bond auctions were renewed in September 2006 and drew the attention mostly of local investors while foreigners opportunistically relocated their funds out of the sizable maturity in mid-November 2006.

The scarcity of available government bonds and better-than-expected macroeconomic fundamentals pushed the yield on the benchmark bond due December 2009 lower by 50bp towards the 9.5% level. The entire government bond yield curve has remained quite stable recently (see Fig 40).

Looking forward, the scarcity effect is likely to persist throughout the current year as the MoF is prepared to add just UAH1.3bn ($0.25bn) to the local government bonds outstanding in 2007. Its total volume of new domestic offerings has been set by the state budget law at UAH3.8bn ($0.75bn), while the volume of local debt due to mature is to amount to UAH2.5bn ($0.50bn). For budget deficit financing, the government has made a strong emphasis on external borrowings again and the MoF is prescribed by law to tap the international capital markets for $1.5bn in funds in 2007.

As the government ended 2006 with a budget deficit of 0.7% of GDP, far below the planned figure of 2.5% set on the eve of 2006, it is well-positioned to meet short-term financing needs. The MoF had about UAH8.63bn ($1.35bn) in the treasury account as at the end of 2006, a comfortable level for the government in terms of managing budget deficits during 1Q07. Hence, this suggests that the MoF will be reluctant in placing new local bonds in the first quarter, they may instead precede or coincide with the year's first large bond redemption of UAH0.85bn that is scheduled in May.

Municipal sector

Municipal bonds, trading at a 200bp premium over local sovereign bonds with Kiev City the exception at yields on par with the sovereign, are offering limited investment opportunities as their total outstanding was only UAH553.5m ($109.6m) as at 31 December 2006. The net increase of bonds outstanding in this segment amounted to UAH38.5m ($7.6m) over 2006.

Looking forward, new offerings of municipal bonds reach an uppermost of UAH250m ($50m) and there are no aggressive plans from municipalities to tap the bond market. Newcomer City of Lviv is expected to offer UAH100m in bonds this year as it has budgeted the bond proceeds in its annual financial plan. Lviv, in the top eight largest cities in the country in terms of population size with about 800 thousand inhabitants, is likely to offer its bonds at a premium over the sovereign as is common with second-tier municipal bonds (like City of Kharkiv, now at a 200bp spread).

Corporate sector

In the corporate bond sector, local banks were the most active borrowers in 2006 and are set to keep this status this year. The fast-growing Ukrainian banks have been actively extending their funding base by issuing debt securities to bond investors abroad and locally. As local bond market rules and procedures are less time consuming and expensive than for international issues, commercial banks prefer to spread their borrowings across the local and international markets. As a result, the share of total outstanding bonds issued by banks is the largest (more than 60%) in the corporate sector.

In January 2007, RZB Bank Aval, a part of Austrian Raiffeisen International, made a noteworthy placement of its local two-tranche bond issue. The primary market yield of the first tranche (UAH250m 5-year bond with an annual put) was 11.15%; another tranche (UAH150m 3-year bullet bond) was placed at a 11.10% yield-to-maturity. The spread over the sovereign yield curve was160bp.

This placement was indicative in terms of further guidance on yields for corporate bonds issued by companies with leading market positions and support from foreign parents. In this regard, the upcoming UAH500m bond by Ukrsotsbank, which is to become a part of Italian Intesa Bank, is likely to see the same tightness in spread over the sovereign.

Recently, the Ukrainian market has seen the emergence of the mortgage bond segment. At the end of December 2006, the government-run State Mortgage Institution (SMI) began the placement of its multi-tranche bond issue with a total volume of UAH1bn. As the bond pays 9.5% on a quarterly basis, there has been interest from investors. While the government guarantees the principal of the bond, SMI reportedly has not launched operations on refinancing bank mortgages and there is also a temporary impediment in the placement of the bond. The matter is that it was registered with the National Depository of Ukraine (NDU), a state-owned depository institution that stood idle over the most part of its life as securities market participants deal with non-government securities mostly via a private depository, MFS, which has been in the business since the 1990s. Though market participants have had to spend some time establishing accounts with the NDU, the SMI bond should be easily circulated among investors.

On 1 March, Ukrgazbank, a private commercial bank owned by Ukrainian investors, is set to offer a UAH-denominated mortgage bond with a total volume of UAH50m maturing in three years and paying 10.5% on a quarterly basis. This is the first mortgage bond of its kind in the local bond market.

Conclusion

• The local bond market is set to experience a scarce offering of government bonds as the MoF's debt policy has a preference for external borrowings. As such, the domestic sovereign yield curve is set to stay within the current range of 9.0-9.5% for the next three to six months.

• Among municipal bond issues, new issues are likely to be rare and look set to continue yielding around 12% per year. Among corporate bonds, tighter spreads (160-200bp over the domestic sovereign yield curve) for top commercial banks with foreign ownership are inevitable following the placement by RZB Bank Aval.