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Some Thoughts on Ukrainian Debt (Part II: Corporate Debt)

Mandelstam versus Milosz

Ukraine is faced with a historic choice that determines whether history will look back on the bloodshed and violence of this on-going crisis and see whether something good came out of it, or a country is yet again swallowed up yet again by a larger neighbor. I do not know the unique character of the Ukrainian people. But it seems highly qualified to balance stability amidst wild movement.

The choice extends from Lviv to the Donetsk People's Republic. It is a choice of what lyrics Ukrainians will be attuned for the foreseeable fruture: the Polish mindset or the Russian mood.

The Polish mindset has an ethical system at its core—belief in values, hierarchy, good and evil, the ugly and the beautiful. The dichotomies arise from the duality in man; to the Pole atrocity has always lurked just below the surface of daily hustle and bustle, habits, social organizations, phrases, and smiles. Poland’s foremost poet, Milosz, reflects this national character in his verse. Poland, still with WWII on its collective mind, wedged between nightmarish totalitarianisms, in uncomfortable disbelief at the complacent and spiritually vacuous state of people when confronted with totalitarian evil.

The Russia Mood in contrast longs for the abstract. It values spiritual matters, ideals uncomplicated by any concrete ties to living things as they are. There is contempt for the complicated and unresolved, the true yet mundane things that are here today and gone tomorrow. In Mandelstam you see a clear reflection of an idealized world, permeated by a hopeless acceptance of human fate. The most fearful thing is change. Thus the attraction to classical examples, grandiloquent severity, and the balancing of sonority and fear in his verse.

This sounds noble, but the cruel reality is that Ukraine is on the brink of default and will almost surely depend on life-support and restructuring if it is avoided. Corporates are very illiquid and show very little interest. Virtually every name is saying that have to extend their maturities. The implicit "or else we default" is unstated but obvious.

The good news is that the IMF is almost surely going to step in with some bridge financing. Germany has committed EUR500 million. The US guaranteed $2 billion in debt. In an extremely strong statement of support, the EU has committed to a EUR1.8 billion aid package. This is life support.

If Ukraine can make the jump from a Russian satrap to a freeer more autonomous state, and avoid defalt at the same time, then there is one corporate worth looking at. The odds are not in its favor. Here's the upside/downside.

The Sweet Spot is Bank Debt

Ukrainian banks provide quasi-sovereign exposure, and are super-cheap to the EUR reference yield curve judging from the euro-denominated yield curve spread for these banks over the reference sovereign yields. We are talking about hundreds of basis points in spread. It is easy to see that corporate debt is priced cheap to the sovereign debt.

Ukrainian Eurbond Pricing.jpg

MHP is the most liquid and stable name in the space, a large vertically integrated agricultural concern that derives plenty of external currency via exports to Europe. PrivatBank is precisely that: the largest private bank in Ukraine. The other two banks are strategically important state-owned entities that finance and to some extent subsidize the Ukrainian export sector. Below is another view that shows the attractiveness of corporates vis-à-vis the sovereign from a yield curve perspective. The 1yr3yr is where the action is. I’m looking deeper at PrivatBank and Ukreximbank. I first the former interesting, while the latter is just a scary punt.

Ukraine Banks Yield curves.jpg

Ukreximbank is a state-owned entity, making bail-out probability high. So much so that Ukreximbank operates as a good proxy for sovereign risk with a spread pick-up. The bank is strategically important, supporting Ukrainian exports and services foreign credit lines provided under sovereign guarantees. It has 30 branches, 93 operating outlets in the Ukraine, and offices in London and New York.

It is the second-largest bank in the Ukraine with assets totaling USD10bn. I expect these asset values to deflate in the next few years as the bank operates in a highly depressed economic environment in Ukraine against the background of a global growth slow-down. As such, profitability will be impacted by the increased need for provisioning, as well as the banks’ involvement in economically unattractive projects that support key government objectives, and not necessarily project with high economic value. It is also heavily reliant on the external market for funding, one third of total funding coming from external debt and loans, which I think is deadly. The next repayment is a $750mm USD bond due on April 2015. I would not touch this given the shape of public finance.

That's the point: the key challenge to this bank is that the government will lean on it to provide policy-driven credits. NPLs peaked at 8.6% in 2010, which is a ghastly figure, but the bank gained experience operating in a challenging environment with flexibility. Case in point, restructured loans climbed substantially to 37% of gross loans by 2011.

Privatbank stands in contrast. It is owned by businessmen individuals Gennady Bogolyubov and Igor Kolomoyskiy with 49.027% and 49.154% stakes, respectively. It is the largest bank in Ukraine with a 10.5% share of total assets, 17% of retail deposits and more than 3,200 branches and outlets and around 7,000 ATMs. It has the dominant domestic franchise and reasonably solid balance sheet given the circumstances. Although it has no government entanglements, its market share in the retail sector boosts its systemic importance and potential bail-out probabilities.

Total assets amount to USD15bn give or take—FX factors make this a tough number to reliably book. Lending operations are the main growth driver over the last few years. Loans to total assets ratio is shrinking and it is profitable in the $50 mln area. Falling provision charges suggest that the asset quality problems are being addressed and getting better, and its latest reported cash position shows growth. In contrast to Ukreximbank, the funding mix of Privatbank is heavily skewed towards deposits, with 75% of its balance sheet supported by customer accounts. Wholesale funding isn’t ingrained and sophisticated in the country yet, and honestly this isn’t a bad thing.

Privatbank statement.jpg

One could argue that undiversified funding sources—depending almost entirely on depositor funds—is a potential problem for bank funding. The conventional wisdom is that depositor money is “slow” money compared to wholesale markets. It may be slow to react to shocks, but depositor money is “stubborn” money. It doesn’t come back easily. However, lessons learned from crisis points suggest that Ukrainian retail depositors are a nervous crowd prepared to pull their funds out of the banking sector at the first sign of trouble. In 2009, bank deposits shrank by some 20% as depositors withdrew their money during the peak of the crisis in late 2008 and early 2009. It is reasonable to expect something like this in the event of a full Russian invasion.

This sudden outflow of funds prompted the National Bank of Ukraine to introduce a temporary moratorium on early withdrawals of deposits, which shattered confidence in a banking system in the event of new crises. For this reason, diversification of their funding base is a strategic task facing Privatbank and others. Yet only a few Ukrainian banks have the structures in place to pass muster for Eurobonds and dollar debt.

This makes Privatbank a breed apart. It is Ukraine’s darling among the international finance set. It has a higher credit rating than the sovereign, but it priced the same as that dog Ukreximbank, and this is exactly the kind of pricing anomaly that I am looking for. It has retail business exposure to Russia via a subsidiary called Moscomprivatbank and a Cyprus branch, which gives the bank some experience with Russian patronage. The financials available are a little stale, but they indicate declining revenue and declining equity cushion.

Privatbank revenue and equity.jpg

Debt issuance shows steep discount to par.

Privatbank issues.jpg
PrivatBank Bond Price Action.jpg

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