Graham Stack in Berlin -

The Ukrainian bond market is tiny, but it could be the seed of something big.

The Ukrainian bond market is worth a mere €11bn, but the volume of bonds will increase by half in the next year as the market finally comes of age.

The politics may be a mess, but with fixed investment increasing by a third in the first half of this year, according to the State Statistics Committee in Kyiv, companies are short of cash and increasingly turning to the underutilized bond market for money.

Fixed investment was up by 54% in the first half of this year in nominal terms to UAH60bn ($11.9bn), with most of the money going into companies in the real sector of the economy such as processing, real estate, transport and industry taking the lion's share.

"In Russia and the West, almost all the bond trading is done on the exchange with automatic settlement. There is very little over-the-counter trading. It means there is almost no counter-party risk," Piotr Grishin, fixed-income analyst at Renaissance Capital, told bne. "That is not true with Ukraine, where the exchanges are underdeveloped, there are problems with registrars, depositories and settlement."

The biggest problem faced by bond traders is that a secondary market has yet to develop. Russia saw rapid diversification of bondholders after its market took off in 2001, but Ukrainian bonds are almost exclusively held by the country's biggest banks, and the small sizes and short maturities mean most tend to hold their paper to maturity.

"The volumes are growing, but the nature of the market has barely changed in the last two or three years. If you look at the breakdown of who is buying bonds three years ago, then you will see very little change to today," says Grishn.

Trading has also been stymied by the short maturities. While the duration of bonds has grown to an average of three years, almost all bonds are issued with six- or nine-month put options built in so most bondholders tend to hold them to maturity. In effect, most bonds are just loans posturing as bonds.

As a result, analysts estimate that less than half of the bonds are tradable. The bulk of issues are still, "technical-issues" that are out of the market. While the share of these pseudo-loans is declining gradually, they still amount for more than half of all registered issues. The main issuers of technical issues are real estate developers issuing bonds to finance apartment purchases and bonds redeemed by housing space.

"Consequently, the main participants in the domestic bond market are Ukrainian banks using bonds as an extra source of liquidity with [repurchase agreement] operations," explains Renaissance Capital's Anastasia Golovach. "95% of bond trades are repo operations, so there is no real trading. It's very different from Russia."

Missing institutions

The domestic bond market also suffers from a marked lack of domestic institutional investors like insurance companies and pension funds, which are traditional consumers of bonds. This means that large Ukrainian corporations, such as in metals and mining, have to turn to international markets to raise funds with Eurobond and syndicated loans. The approximately 200 domestic bond issuers are made up mostly of local banks and smaller Ukrainian companies, especially from the rapidly growing retail and food production sectors.

"Companies issue bonds for various needs: to expand production, to invest in new technologies and equipment. Banks use money to expand credit portfolios. Bonds are attractive instruments to attract financing for a company, as it requires no collateral as a loan agreement usually does," says Dragon Capital's Andriy Dmytrenko.

So while it may be tiny, the local bond market does provide a valuable way of raising unsecured debt and tapping the growing pool of liquidity in the fragmented banking sector.

Foreign investors - largely hedge funds - are a possible source of liquidity to substitute for domestic institutional investors, but they are only now dipping their toes into the corporate bond market. Until investors other than banks appear, the secondary market will struggle to get off the ground.

However, equity financing is not yet a real alternative to bonds issues. "At the moment, the domestic bond market is a company financial director's second port of call after banks; equity is only the third option," says ING's Alexander Valchyshen.

Valyschen estimates new domestic bond offerings in 2007 at UAH4bn. "I'm sure that bond trading has contributed more to growth in securities trading volumes this year than equities.

The lack of a secondary market is a severe problem, but seems likely to be mitigated by new requirements increasing transparency. This year has seen a new requirement making it obligatory for all bond issuers to obtain a credit rating. "This has created more awareness among issuers of the importance of disclosure," says Valchyshen, who is positive about legal regulation and infrastructure developments.

"The bond market has been established and functioning for a while. Some technical improvements in trading and settlement are still required, and these are likely in the upcoming year, and will bring more transparency to both primary and secondary markets," he says.

Valyschen sees everything in place for a surge in growth on the bond market: "Currently, the bond market amounts only to 1.5% of GDP - it is really tiny. But everything is in place, so the only way is up."

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