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Ukraine's About to Embarrass Some Investors

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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Bond guru Michael Hasenstab has probably made the most embarrassing mistake of his stellar career. Ukraine, on whose bonds he made a risky bet while President Viktor Yanukovych was still in power, is beginning to talk to international creditors about restructuring its foreign debt. The negotiations will be tricky, and even if the Ukrainian government makes its inevitable default relatively painless, Hasenstab stands to lose significant money on his investment.

Ukraine has asked the IMF to replace its $17 billion, short-term "stand-by agreement" with a longer-term "extended fund facility," contingent on a reform plan stretching over several years. A press release from IMF Managing Director Christine Lagarde makes it sound like a done deal. That's good news for Ukraine: Funds from the IMF are a lifeline for an economy in which tax collection is in disarray, the customs service has been unable to overcome chronic corruption and industries responsible for about 15 percent of GDP are stuck in a festering war zone in the country's east.

Ukraine is facing a $15 billion budget shortfall in 2015 (the U.S. and EU have so far pledged only about a quarter of that amount) and according to Standard & Poor's, it has $11 billion in hard-currency denominated debt repayments due this year, although its foreign reserves stood at just $7.5 billion at the beginning of this month. Serhiy Fursa, a fixed income specialist at Kiev-based Dragon Capital, has argued that much of the $11 billion may be domestic dollar-denominated bonds held by state-owned banks that routinely roll over such debts; according to him, all Ukraine truly has to worry about is $4.2 billion in eurobond redemptions, $3 billion of which is debt owed to Russia on a special bond issue engineered in 2013 to prop up Yanukovych. Evidently, however, the Ukrainian government doesn't believe it can get off so lightly.

In a press release she published on Facebook, Ukrainian Finance Minister Natalie Jaresko explained that, as part of the new IMF deal, the ministry will hold "consultations" with the holders of Ukrainian debt to "improve medium-term financial stability." According to Jaresko, "the markets expected such a step and should take it favorably because it will provide financial support necessary for Ukraine to quickly launch its economic renewal and will bring about positive results for all interesting parties."

Indeed, the markets have been expecting Ukraine to default. The credit default swap spread on Ukrainian debt stands at 2,755 basis points, up 40 percent so far this month, meaning it costs $275,500 a year to insure $1 million of this debt against default. Among all sovereign issuers, only Venezuela has a higher insurance premium. If Ukraine can offer decent terms to its creditors -- a moderate maturity extension, perhaps slightly lower coupon income -- Ukrainian bonds, which now trade below 60 cents on the dollar, may actually gain value. Such a mild, voluntary restructuring -- or reprofiling, as another euphemism goes -- would not trigger the CDS, and would probably drive down the spread because the short-term probability of default would be reduced.

Still, even a friendly deal would constitute a default, according to the Standard&Poor's definition. And Ukraine faces a potential problem because of the eurobond held by Russia. According to its terms, Moscow can demand early repayment if Ukraine's ratio of debt to gross domestic product exceeds 60 percent. It stands at 75 percent now: Ukraine owes $134 billion to external creditors, and it had a GDP of $177 billion in 2014. Russia has not yet take the opportunity to demand the money, but relations between the two countries are rapidly deteriorating again as fighting grows more heated in eastern Ukraine. 

Earlier this week, the foreign ministers of Ukraine and Russia, with the help of their French and German colleagues, agreed in Berlin that that Ukraine and the pro-Russian rebels should pull back their artillery from a demarcation line agreed to last September. The problem with that deal is that the line itself is disputed because it was not described precisely in the September agreements. The rebels have exploited that ambiguity to make territorial gains, extended them in recent days to take over the ruined Donetsk airport, long seen as a symbol of Ukrainian resistance to the Russian and Russian-inspired aggression. Fighting and shelling has continued today despite the new agreements.

That makes it tricky for Jaresko to discuss a debt rollover with her Moscow counterpart, Anton Siluanov. If, however, Ukraine pays off Moscow in full -- it still has the reserves to do so, even before it gets any more money from the IMF -- other bondholders will need to show understanding for Kiev's political situation when they are asked to wait longer for repayment or sacrifice some coupon income. 

Hasenstab will be an important figure in these negotiations. He runs bond funds for Templeton that held $8.8 billion of Ukrainian debt at the end of September 2014. (They have not yet reported newer data.) In June, the fund manager, who has won big on Irish and Hungarian debt in the past, painted a rosy picture of this investment:

As a dollar-based investor, we're not taking foreign-exchange risk, we're taking dollar-denominated Ukrainian government bonds, in a country that has 40% debt to GDP. It was never a solvency issue. It was more one of liquidity, and recently with the IMF package, International aid support, Ukraine will access over the next couple of years, because of their good reform agenda, over $30 billion of international assistance. So with solvency intact, with liquidity intact, what we liked was that everyone was just looking at some of the noisy headlines and not going to the country and understanding the underlying fundamentals, and we think long-term it's a good investment opportunity.

At that time, however, some Ukrainian bonds were trading close to par value. Hasenstab, who had bought the instruments at about 80 cents to the dollar, could afford to be sanguine. Now, with the restructuring coming up, and with Ukraine's debt level mounting as its GDP continues to slide, he will probably have to fix a loss on the whole portfolio. 

Granted, it only constitutes a small part of the $185 billion in bonds he runs for Templeton, but for someone who has a reputation as a successful contrarian to maintain, the almost inevitable restructuring is a blow quite out of proportion to the actual financial effect of the losses. Besides, Hasenstab's recent record has already been uncharacteristically weak. The one-year performance of his biggest find, Templeton Global Bond is only in the 54th percentile of his peers, and this month, it's in the lowly 27th percentile so far.

The lesson here is that investing on the basis of fundamentals and ignoring those "noisy headlines" is not always a good idea. When geopolitics intervene, fundamentals can change quickly and unpredictably. Perhaps Goldman Sachs and some big insurance companies, which unloaded Ukrainian bonds last year, were right to pay more attention to the news.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net