The case of Ukraine: Bond prices reflect invasion, not increased international financing
Ukrainian bonds collapsed after the Russian invasion. At the moment, we are accumulating bonds, because we believe that a Ukraine capable of financing itself easily is likely to emerge.
Ukrainian bonds have become very cheap relative to history. Ukrainian bonds collapsed after the Russian invasion. Coin 1 shows Ukrainian 22 and 33 years. Short-term bonds are now trading at around 36 cents on the dollar, while longer-term bonds are trading around 23. The market is clearly pricing in the certainty of default. If Ukraine manages until September, the rise is obviously spectacular. If Ukraine’s ability to pay is seen to be more permanently intact, then the advantage both front-end and long-term is also obviously dramatic.
Piece 1 – Ukraine years 22 and 33
Ukrainian International Bonds Course
Source: Bloomberg. Data as of March 8, 2022.
Ukraine is likely to be self-financing. Table 2 below shows Ukraine’s external financing needs, and its financing, for 2020, 2021 and projections for 2022. The key thing to note is that the $2.7 billion in 2022 was entirely financed by the official sector, before additional support that is announced for Ukraine.
Exhibit 2 – Ukraine’s external financing in 2022
Ukraine: program funding (billions of dollars)
Ukraine sees better what had been a key constraint for us to own it – its policy/policy test score is to improvewe believe. Now, the above is just saying that we believe Ukraine is cheap relative to history and can fund itself, which is pretty important. But, of course, Ukraine faces the ultimate political challenge: an invasion. Fortunately, our process incorporates such unsystematic risks. This is the point of step 2 of our investment process. After step 1, in which we generate a list of what we consider to be the cheapest emerging market (“EM”) bonds based on a purely systematic and quantitative framework, we have step 2. Stage 2 incorporates non-systematic risks, but on a consistent basis. We apply Stage 2 tests to all emerging bonds and fortunately material non-systematic risks such as invasion are quite rare. We won’t bore you with the three tests that make up Stage 2, but the key test in the Ukrainian situation is the Politics/Politics test. Why are we assigning a less pessimistic/more optimistic rating here?
There has been a wave of international support for Ukraine that dwarfs its external financing needs. Not only is Ukraine already funded by official creditors, but the amount of funding that appears to be in the pipeline in response to Ukraine’s invasion dwarfs current funding.
- First, the EU has just welcomed Ukraine’s application for EU membership. EU membership and membership anchoring policy (membership is conditioned by policy). But EU membership also comes with significant funding. In countries like Poland, for example, it provides about 10% of budget financing. Joining the EU transformed politics and led to a convergence of credit spreads in virtually all Eastern European countries.
- The United States Congress is currently considering legislation to provide Ukraine with $6 billion to $10 billion in aid.
- The IMF announced additional financing of $1.4 billion, via a Rapid Financing Instrument (“RFI”) line.
- The IMF should show great leniency, reflecting the attitude of the international community. This is normal in situations like this, but the degree of international sympathy seems extremely high in this case, based on our decades of reviewing such programs. Concretely, this means that if “market financing” (in the case of Ukraine, assumed to be $2.5 billion in issuance) does not occur due to the invasion, the IMF is very likely to compensate.
- Ukraine’s Ministry of Finance recently informed us and other investors that all regions continue to provide revenue to the central government. Remember that Crimea, Donetsk and Lugansk (the latter two have just seceded from Ukraine) are already excluded from Ukraine’s financing assumptions, so this risk is already taken into account.
- The Ministry of Finance has committed to continue paying its obligations and has paid the coupon due on February 28, 2022.
- Military spending could rise, but recent pledges from Germany and the EU mean it will likely be financed from abroad in the future.
- There will be significant reconstruction costs, but we believe these will likely be funded by international bilateral and multilateral agencies. EU membership will be an integral part of this. Also, all investments in Ukraine are obviously frozen right now, so many of those resources could be redeployed after the end of hostilities.
Our conclusion is that Ukrainian bonds reflect the fact of invasion, but not the likelihood of further international support. As a result, we accumulate obligations. We do not overlook the fact that with Russia taking Kyiv, Ukrainian bonds could suffer more. But, once the dust settles, we believe that an easily funded Ukraine is likely to emerge. We obviously cannot wait for this scenario to become evident, as bonds will have widened higher. As a result, we accumulate.
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Originally posted by VanEck on March 11, 2022