Will Ukraine’s bondholders force a default on purpose?

(Business New Europe – bne.eu – Ben Aris in Moscow – May 26, 2015)

Will Ukraine’s private bondholders force the country to default on its debt on purpose by refusing to negotiate on the restructuring, or “haircut”, that Kyiv is demanding on $10bn worth of debt?

It’s not such a crazy question, because it has happened before. In 2009, Morgan Stanley, which held a lot of the bonds of troubled Kazakh lender BTA Bank, suddenly called the loans in, causing the bank to default – despite both the Kazakh government and the bank itself bending over backwards to treat creditors well, and negotiate in good faith to get through an extremely sticky patch.

It transpired later that Morgan Stanley had bought a lot of credit default swap (CDS) contracts, a financial instrument that in effect insures bondholders against the possibility of the issuer defaulting on a bond. It emerged that Morgan Stanley had bought CDS to a value greater than the value of its investment in the bonds, so the US bank made money on the trade. In the world of finance it is, in effect, perfectly legal to take out life insurance on your wife and then murder her for the money. The bank has never commented on the deal, but it caused a great deal of comment on the shortcomings of CDS in the aftermath.

Analysts in Kyiv believe it is unlikely the same thing will happen this time, simply because the amount of money involved is so large: the creditor committee that is negotiating with the government on the possible haircut hold over $10bn of debt, whereas the BTA bond was worth a few hundred million dollars. “No one knows for sure, but the amount of money is so large it is unlikely that the creditors could buy enough CDS to cover the whole outstanding amount,” says Alexander Paraschiy, a fixed-income analyst with Concorde Capital in Ukraine.

CDS spreads on Ukraine’s bonds have been soaring as negotiations between Ukraine and the bondholder committee become increasingly tense as a mid-June deadline set by the International Monetary Fund (IMF) requiring final agreement on terms draws close. As bne IntelliNews reported, Ukraine’s finance ministry took its dispute over the debt restructuring public, criticising bondholders over the secrecy of their identities. They in turn attacked Kyiv’s insistence on forcing a haircut on the debt.

US-born Ukrainian Finance Minister Natalie Jaresko has said that the government is “concerned” about the approach taken by the ad hoc committee, which has refused to meet the minister face to face for talks. The committee made a concession on May 20 by revealing some of their names – it comprises funds managed or advised by BTG Pactual Europe, Franklin Advisers, TCW Investment Management Company and T. Rowe Price Associates – but serious talks still do not seemed to have started. “The Committee and their advisers are in regular contact with additional holders of the Notes who, together with the Committee, represent in excess of $10 billion of Ukrainian debt,” a statement from the bondholders said, but gave no details on talks, if any, with Ukraine’s finance ministry.

In other words, the bondholders are being difficult as the clock runs down, making it increasingly likely the government will simply refuse to pay them by the IMF deadline. In an ominous sign, Ukraine passed a law allowing the government to impose a moratorium on the payment of bond coupons on May 20. “To protect the interests of Ukrainian people, the Government of Ukraine submits to the Verkhovna Rada today the draft laws, those enabling the Government to suspend payments on certain external public debts and guaranteed by the government debts, as specified in the Annex to the relevant Regulation of the Cabinet of Ministers,” the government said in a statement. “But by adopting this law we appeal to our foreign lenders with a request to support Ukraine and share the heavy burden with us.”

The talks between the two sides have been described as “deadlocked”, but they don’t seem to be happening at all. About $23bn worth of sovereign and sub-sovereign debt is earmarked for restructuring in total over five years, out of a total of about $40bn outstanding.

Betting on a default

At this point investors seem to be assuming that the bondholders are playing chicken with Ukraine’s government and some sort of deal will be thrashed out at the last minute. “Of course it is not clear what will happen, but our working assumption is that there will be a debt writeoff of about 50% and a deal will be done,” says Charlie Robinson, head of research at Renaissance Capital. Many commentators are putting the chances of default at about 50/50.

However, the prices of CDS imply a 95% chance of default on its one-year bonds at least, according to data provider Markit. The CDS spreads over par (0% change of default) have soared in the last two years. Ukraine’s bonds were always seen as a bit iffy and have not traded below 500 basis points (bp) since August 2011, which means it would cost $500,000 a year to insure $10mn worth of bonds over five years.

But CDS spreads have soared in the last couple of years on the back of the drama being played out in Ukraine. Spreads shot up to 1,325bp on the day after former Ukrainian president Viktor Yanukovych was ousted on February 19, 2014, before sinking back to under 1,000bp after the new government came in.

More recently, the spread has been climbing again after the IMF and government in Kyiv announced their desire to impose a “haircut”, topping 3,239bp as of May 20, according to data provider Markit, which suggests the insurers at least have little faith in an amicable settlement.

Ultimately, the IMF will play the decisive role on deciding what is to be done about the bonds – whether the government will place a moratorium on the coupon payments, which counts as a default, or a deal is cut to delay the payments and leave the principle amount untouched, as the Russians did to their bondholders following the 1998 ruble crisis. “Currently, the IMF is the key creditor to the whole Ukrainian economy so everything will depend on the IMF’s position,” says Paraschiy. “If they think that a moratorium will not affect the fund’s loan programme, then everything will be fine with Ukraine.”