Ukraine Debt Deal Shows Cracks Emerging in Russia Bond Strategy

  • Russia bond excluded from better terms for notes maturing 2015
  • Bondholders prepare to vote on debt restructuring by Oct. 14

Ukraine’s policy of treating all bondholders equally is starting to show cracks where the $3 billion owed to Russia is concerned.

After months of insisting that the war wouldn’t stop Ukraine handling Russia just like any other foreign bondholder, the government in Kiev agreed to a sweetened deal last week for all other holders of Eurobonds maturing this year. Russia, for its part, has refused to negotiate, demanding payment in full on its note due in December.

While Ukraine has yet to signal its intentions on the debt Russia bought just months before President Vladimir Putin annexed Crimea, its refusal to pay would risk confrontation over a $17.5 billion International Monetary Fund loan. At the same time, making payment will drain resources needed to lift the economy out of a recession.

"Ukraine sees the Russia bond as a distinct category and they’re at pains to show it," said Anna Gelpern, a Georgetown University law professor and fellow at the Peterson Institute for International Economics. "They will have to negotiate the bond bilaterally with Russia, but probably not until after the other bonds are restructured."

Ukraine’s Finance Minister Natalie Jaresko said last month paying Russia in full on the bond it inherited from the regime of former President Viktor Yanukovych is "not an option." Still, missing payment when the debt matures Dec. 20 could threaten the loss of the IMF bailout as the fund’s policy dictates it doesn’t lend to countries in arrears to sovereign creditors.

The IMF will only decide if it thinks the bond is official debt after Ukraine has gone into arrears, according to Nikolay Gueorguiev, the IMF Mission Chief to Ukraine. The preliminary view by staff at the crisis lender is that the bond should be classified as official debt, a person familiar with the matter told Bloomberg in June.

Russian Finance Minister Anton Siluanov warned on Sept. 8 that Russia will seek legal action against Ukraine and will question the validity of the IMF program, if the bond isn’t paid back in full.

Ukraine invited Russia, along with its other Eurobond holders to vote by Oct. 14 on the debt-restructuring deal, which includes a 20 percent principal writedown, higher average coupons and warrants tied to gross domestic product growth. Ukraine’s Eurobonds have rallied since the deal was announced late last month, with notes due July 2017 advancing 23 cents to 78.8 cents on the dollar.

Holders of a bond that matured last week and one that is due Oct. 13 will have their securities swapped into a new note maturing in 2019, following the request of a group of creditors with more than 25 percent of the September 2015 bond. All other investors are being asked to accept a share of a  new bonds due from 2019 to 2027.

Isolating Russia

The deal isolates the bond owed to Russia by reducing the risk of holdouts on the other bonds. If all other holders agree to restructure, their bonds will be swapped into new notes without cross-default clauses, reducing the fallout from a missed payment to Russia.

"The tactical thing for Russia might have been to say that it wasn’t just them that was being treated badly," said Gabriel Sterne, head of macro research at Oxford Economics in London "But now Ukraine can just say, well the other short-maturity creditors have reached a deal, why can’t you?"

Russia will probably agree to restructure the bond, according to 10 of the 19 economists polled in a Bloomberg survey last week. Six said the security will be repaid. Ukraine will probably wait until the other bondholders approve the restructuring before holding bilateral talks with Russia to discuss different terms, according to Gelpern at Georgetown University.

While both sides have indicated unwillingness to compromise on the bond payment, the countries reached agreement on a natural-gas deal mediated by the European Union on Saturday to ensure Ukraine will get supplies until March. Also at stake is a fragile ceasefire with pro-Russian separatists in Ukraine’s east. 

"It is still not clear at this stage what will happen to the Russian bond," Stuart Culverhouse, London-based chief economist at Exotix Partners LLP, said in an e-mailed note on Sept. 25. "Russia has consistently said it expects to get paid, and this concession might give it some hope that it too can extract better terms, as a precedent of preferential treatment has now been set."

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