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Some Thoughts on Ukrainian Credit (Part I: Sovereign Debt)

Ukrainians seem to yell a lot—not in an angry way, just in a loud and boisterous way. They have good reason to yell. As a people, they stand at a unique point in history. These point only come along every century or so. Will this point end in Ukrainian mean reversion or will Ukraine begin a journey that breaks with the mean and arrives at some new and far point?

Go back a century of so: Lviv was one of the most cosmopolitan places in the world. It was common to hear a conversation between two people shifting effortlessly between Ukrainian, Polish, Russian, Yiddish, French, maybe even some Hungarian. It was a stew spiced by Polish gallantry, the rough kindliness of Ukrainian hospitality, Jewish brains. This was the city of Stefan Banach, the great systematizer of functional analysis, patron saint of all nerdy and alcoholic mathematicians. Ukrainian cities were the strung pearls of Europe’s hinterland.

World War II and Communism combined to rape and destroyed almost all of it. Banach and his functional analysis school fled. Millions were purposely starved in an attempt to break the collective spirit. Yiddish faced extinction. Pre-war Ukraine was a lost world.

History may never repeat exactly, but like song, it has a familiar refrain. An important historical refrain has come around again: Ukraine is faced with the need to choose between 1) a more cosmopolitan openness that comes with alignment with Poland or 2) to walk in the yoke of Russian backwardness. Through Poland comes alignment with France, and through French alignment comes all of continental Europe. Russia to this day bears scars and insecurities from Mongolian cruelties inflicted centuries ago.

Simply put, Ukraine has the choice to get rid of kleptocracy and cronyism and emerge as one of the least corrupt, pro-business, pro-West countries in the frontier market space. The Russian invasion of Crimea diverts attention from this cleansing process and makes the choice existential. In the face of this, investing in Ukraine is heroics. And it regains the nobility and power of investing, because individually small insular acts that few value work to build civilization incrementally. It opposes destructive aggression and predation with taking the risk to trust that dark forces will not bring it down in a smoldering heap. It is at the same time meaningful and profitable work.

What the Russian invasion should do is re-set valuations to better represent the risks we see going forward. Not everywhere, but there should be places along the capital structure where the terrain looks appealing and the bad news and dismal outlook makes things look absolutely cheap.

Ukrainian Sovereign Eurobonds: Yield Curve, Pricing, and Trading

In the “yes, there is a disaster impending” evidence category, the Ukrainian yield curve is seriously inverted. If you don’t know what curve inversion means in a technical sense, then take it intuitively as an expression of a collective expectation that the present is better than the future will be. It is a dim view of prospects. Curve inversions mean hard times are imminent or current, yet the future seems even worse. The curve is priced for a near-term default.

Ukraine euro yield curve.jpg

On a price basis, these bonds are priced like distressed debt. Given what looks like absolute dependence on foreign subsidies like Russian natural gas price breaks and dependence on subsidized foreign credit like foreign aid and IMF loans, the mid-price of these bonds are discounted from par anywhere from 2% on the front-end to 36% on the back-end.

Ukraine euro bonds prices.jpg

Think about it this way: you are paying €8,040 for €10,000 1Y par units with a 62% yield. You will accrue about €1,200 in interest in the first year with yield to maturity of 48.23%. The discount off par prices already 60% wipe-out of principal. Assuming 40% recovery, you will end up with €7,877 on an initial investment of €8,040.

On generic debt you can deliver into a credit default swap, the implied probability of default with the same assumption stands at about 17% as of January 1, 2015. So the market is giving these bonds a one in six chance of default, pricing in a 3% loss in the event of that default, and a 48.23% upside if the bonds don’t default.

I’m skeptical about these default probabilities. Firstly because they assume 40% recovery, and secondly, there is not a lot of depth in this market. Given this, the discount doesn’t look nearly as attractive. From the looks of the data, 40% is not the standard view taken for recovery prospects in Ukrainian debt (based on implied Pr(default) and CDS spread premium being tighter than what is shown).

From a trading perspective, volatility is definite and focused in local currency bonds. In November-December 2013, the local currency bonds jumped in value after a $15 billion pledge by Russia averted the risk of default: pure sell signal. This is, in fact, what likely prompted the Russian invasion. Putin made this $15 billion pledge on loan-shark terms to Ukraine and when his puppet get sacked and nearly strung up by the ankles in a mini-revolution, he saw as a peasant revolt to be put down in a satellite country. What looked like an apparent buying opportunity in February 2014, but tensions mounted into the year and bond prices slumped further.

This trade turned out to be a real killer until the US and EU picked up the tab in the summer. Then you saw a massive mean reversion and overshoot. The downside is that trading possibilities are based on politics. So buy and sell signals diffuse through the prism of sensationalist headlines, the commitments of noncommittal politicians, and out-of-the-blue announcements.


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