December 18, 2013 / 8:30 PM / 4 years ago

Ukraine bond rally rewards audacious big-name investors

LONDON, Dec 18 (Reuters) - A jump in prices of Ukraine's dollar bonds since Russia offered a $15 billion bailout has vindicated some of the world's biggest investors who bet billions that the high-yield, high-risk creditor could avert default.

President Vladimir Putin's promise to buy Ukrainian debt in a deal dictated more by geopolitics than economics has postponed rather than eliminated the risk of Kiev defaulting.

Nevertheless, the audacity of funds such as Templeton, Fidelity, Amundi and Goldman Sachs - all of which piled into what is easily one of the world's riskiest debts - has been rewarded.

Some even stepped up their Ukrainian bond holdings when the market was falling in the second half of this year before Putin struck the deal with Ukrainian President Viktor Yanukovich on Tuesday, data from Thomson Reuters company Lipper shows.

Ukrainian bonds have jumped by 7 to 10 cents in the dollar and some yields have halved from recent record highs since Moscow promised to lend Kiev the $15 billion and slash its gas import bills by around a third.

This bailout shores up Kiev's rapidly foreign dwindling exchange reserve, staves off a collapse of the hryvnia currency and should ensure repayment of around $7 billion in foreign debt due over the coming year.

Fidelity's emerging market debt fund was among those that increased their Ukrainian holdings when the market was falling.

"We knew the fundamentals in Ukraine were sub-par and we were concerned about default risk, but the models we run look at valuation and risk premium and those suggested we would be compensated for taking the risk," said Steve Ellis, a portfolio manager at Fidelity Worldwide Investments which has a total $160 billion in assets.

Ellis has proportionately slightly more invested in Ukraine than its weighting in the underlying index, and said he planned to maintain this small overweight position for now, rather than cashing in on this week's gains.

"The market has rallied significantly and as a trader you should be thinking of reducing risk after such a rally, but valuations suggest there is still a bit of value left and we think we can squeeze out some more gains."

Details remain hazy of the Russian bailout, which aims to keep the former Soviet republic under Moscow's influence after Kiev walked away from a trade deal with the European Union.

However, the promise has boosted Ukrainian bonds across the curve and cut the cost of insuring the debt by a third in the credit default swap markets. CDS now price a 40 percent default risk over five years, versus over 50 percent late last week, according to Markit data.

Short-dated debt, where the big funds are heavily invested, took the hardest pounding in recent weeks but are also rallying hardest. Yields on the 2014 bond, for instance, have collapsed to 8.5 percent from 20 percent-plus last week.

The 2014 bond from state energy firm Naftogaz has also jumped 10 cents in the dollar from the lows hit last week.

"From an investor's perspective it doesn't matter if the money comes from the IMF or European Union or Russia. As investors we look for the country to fix its financing with regard to the current account and debt repayments," said Sergei Strigo, head of emerging debt at Amundi, which has a total $1 trillion under management.

He had expected either Russia or Europe to provide aid eventually, he said, but added: "It was a good day yesterday."

YIELD AND COUPON

Default fears of not, Ukraine is hard to ignore, given its 3 percent weight in the emerging bond benchmark, the JPMorgan's EMBI Global index. The bonds also offer high fixed interest rates - or coupons - which are costly to shun.

Like Ellis of Fidelity, many investors judged the coupon cost of avoiding Ukraine as higher than the default risk. Yields are among the highest on the index, and the coupons can be as high as 9.5 percent.

Ukraine debt has lost almost 10 percent of its value this year, making it among the worst performers on the index. Nevertheless, a fund manager holding the bonds on a repayment bet, would have enjoyed an 8 percent-plus return on coupons - among the highest on the index, according to JPMorgan data.

The presence of big investors, including Templeton star bond fund manager Michael Hasenstab, in Ukrainian debt has also helped to soothe fears..

DISAPPOINTMENT

Even before the bailout, Ukraine's bonds had made some gains off lows, with analysts at Bank of America/Merrill Lynch for instance advising clients to raise their allocations on the assumption that the bad news had already been priced in.

But further gains could be limited. Firstly, the bonds did not fall below 80-85 cents for every dollar of face value, possibly supported by the big buy-and-hold investors and secondly, the Russian loan is a stop-gap rather than a long-term game changer for Ukraine.

Strigo of Amundi said Ukraine was likely to hobble on with more debt issuance, soon pushing its currently low debt ratio to over 50 percent of its annual economic output.

Like most funds canvassed for this report, Strigo was underweight longer-dated Ukrainian bonds, noting that the country's recession, a fixed and overvalued currency and a big current account deficit remained.

Also, Russia has demanded none of the reforms that would be attached to any bailout from the International Monetary Fund or the EU, meaning Ukraine can dodge vital but unpopular measures for a while.

"A two-year financing hole is being gapped but in absence of reform we will be revisiting this issue in two years time," Ellis of Fidelity said. "The hump in default risk has just moved by a few years."

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