Despite an unpromising external and domestic background, the
Republic of Ukraine has continued to use international capital
markets this year in a manner that has flabbergasted investment
bankers. To some, the country's willingness to pay stratospheric
new issue spreads simply indicates Ukraine's willingness to give
international investors what they want - at a time when domestic
funding is prohibitively expensive.
To others, however, the move smacks of plain desperation - at a
time when the country's economic and political situation appears
far from stable.
THE REPUBLIC OF UKRAINE IS THE most recent addition to the list
of central and eastern European sovereign issuers in the
international bond markets.
As a result - and perhaps more than any other issuer from the region so far - Ukraine has had to run the full gamut of investor opinion over the past year.
Welcomed with open arms last summer when bullish sentiment in the emerging market debt sector was approaching its peak, Ukraine has since had to fight hard to maintain access to international capital in the wake of the Asian crisis and against a backdrop of an increasingly uncertain economic and political situation at home.
Despite these unpromising domestic and external factors, Ukraine has already managed to raise $1.1bn this year through a series of bold initiatives in the international capital markets - securing a unique position for itself in the eyes of yield-starved European investors.
Whether the financially strapped country can afford to continue with such a strategy remains open to question. But the broadly positive reception accorded to the sovereign issues has already encouraged regional and municipal credits in Ukraine to consider launching their own Eurobond debuts.
Ukraine's maiden international bond issue in August 1997 came as something of a surprise, but was nevertheless a pleasant one in most people's eyes.
The country had not been expected to make its debut in the Euromarkets until the fourth quarter with a $500m fixed rate Eurobond mandated to Deutsche Morgan Grenfell and JP Morgan, following a Nomura-led $250m equivalent Samurai issue.
However, the Ukrainian authorities opted instead to capitalise on a long-awaited agreement with the International Monetary Fund (IMF) for a much needed standby facility to establish a benchmark for its debt in dollars, which for most central and eastern European issuers remains the currency of choice for market debuts.
The Nomura-led $450m one year issue was structured as a zero coupon bond offering an attractive yield of 325bp over 12 month dollar Libor.
That the issue was unrated and was launched at the height of the summer holiday failed to hinder the rapid distribution of the paper.
Given the positive price and spread performance on previous sovereign issues out of central and eastern Europe, investors were keen to gain first time exposure to the last of the region's major economies to come to the international bond markets.
From a fixed re-offer price of 91.30 at launch, the issue traded up strongly in the aftermarket to close the first week's trading at 91.85 bid, 91.95 offered, with the spread narrowing to 280bp/270bp.
Nomura reported that the initial bid for paper had come from Europe, but that there had also been strong follow-through buying by Asian and offshore US accounts.
International money market and emerging market funds, banks, corporate treasuries and retail investors all participated in the issue, which market participants agreed was correctly priced for a debut sovereign issue and boded well for the dollar and yen issues planned for later in the year.
Ukraine's finance minister, Ihor Mityukov, commented: "This issue is the crucial first step in establishing Ukraine in the international capital markets and in diversifying our funding sources. We intend to continue to develop our capital markets programme, obtaining credit ratings, expanding maturities, and diversifying currencies at the appropriate time."
While those comments still reflect the thrust of Ukraine's international funding policy, the price the country has since had to pay for continued access to the international capital markets is far removed from that in August 1997.
While in the two months after launch the dollar issue continued to perform well - with the spread narrowing to a low of 190bp - it soon fell victim to the Asian contagion which laid low the whole of central and eastern Europe in the final two months of 1997.
The emerging market sell-off hit Ukraine particularly hard, with the spread on the sovereign Eurodollar bond ballooning to 1,350bp at one point.
Yields in the Ukrainian T-bill market - which had fallen steadily over the course of 1997, thanks to increased participation by international investors looking for an investment alternative to the Russian T-bill market - spiked dramatically as the market was hit by a liquidity crunch in the domestic banking sector and the retreat of international investors.
The Ukrainian currency, the hryvnia, also became the focus of the currency speculators, further increasing the pressure on the Ukrainian government's financing costs.
With access to the international bond markets effectively barred due to investor bearishness towards all emerging market credits, Ukraine turned to Merrill Lynch in late December to help it out of its pressing funding predicament.
The US investment bank came up with a internationally targeted Hrv750m T-bill financing package, which netted the country net proceeds of $250m-$300m. Two parallel issues of nine and 12 month paper were launched, with investors offered either T-bills in either standard or repackaged form.
The one-off issue was priced to yield 44% - in line with the local T-bill yields - and featured downside protection in the form of an embedded minimum dollar yield of 21%.
Merrill reported that the issue had attracted a broad range of first time investors to Ukraine, headed by European accounts, but also featuring US and Asian participation.
While the T-bill issue proved a useful short term solution to Ukraine's funding woes, in 1998 the country has adopted a bolder - some would argue foolhardy - approach to its borrowing requirements.
With its budget deficit widening and domestic funding costs rising, Ukraine has latched on to the growing desire among international investors for high yield product to raise money overseas on a frequent basis.
This new tactic has not found universal favour, however. As one London-based syndicate head acidly observed: "Trying to borrow your way out of a budget deficit problem probably isn't the cleverest thing to do."
And certainly the vigour with which the Ukrainian government have gone about soliciting international bond proposals - at one point, the country had at least five funding ideas on the go at once - has led to the bizarre charge of 'mandate incontinence' by some bankers.
Furthermore, the country has also fallen foul of the international development agencies, with both the IMF and the World Bank suspending the release of funds as a result of what they regard as a lack of progress on economic reforms.
Nevertheless, Ukraine has ploughed on with its plans for regular international bond issuance as part of its $4.54bn overseas borrowing requirement for 1998 - and the results to date have boosted the Ukrainian authorities' room for economic manoeuvre, if only in the short term.
The country has also made it onto the ladder of internationally rated issuers - albeit near the bottom rung. In late October, with the help of Nomura, the country secured a BB+ rating from Nippon Investors Service, while JP Morgan and Deutsche Morgan Grenfell advised Ukraine on its B2 rating from Moody's, which was awarded in early February.
Ironically, the issues for which these ratings were originally solicited - Nomura's $250m equivalent Samurai bond and the $500m Eurodollar offering via Deutsche Morgan Grenfell and JP Morgan - have both failed to see the light of day.
The still unresolved turmoil in Japanese financial markets has put paid to hopes of a yen issue for the time being at least, while dollar investors have by and large remained immune to Ukraine's charms, balking at the country's creditworthiness regardless of price.
SBC Warburg Dillon Read failed to get a $100m-$150m one year dollar Eurobond off the ground in January, despite price talk involving a 17%-20% coupon.
Moody's trenchant criticism in its ratings summary - stating that "although Ukraine is not poor in natural and human resources, the government has been halting and ineffectual in its approach to economic reform following the country's independence in 1991" - will have done little to persuade dollar investors of the merits of Ukraine's credit story.
Undeterred by the setback to its ambitions in the dollar market, however, the country has set about targeting European currency sectors with gusto.
Despite misgivings in some quarters over the strength of the country's economy - some bankers felt that it was far closer to default than it was to meeting Maastricht criteria, as claimed by Ukrainian officials at investor presentations - Ukraine's first Euro-DM issue proved a blow-out success at launch in mid-February.
Overwhelming investor demand for high yield Deutschmark product enabled joint lead managers Commerzbank and Merrill Lynch to launch the three year issue for a larger than expected DM750m - versus an indicative size range of DM300m-DM500m - and to price the deal at the bottom end of the 16%-18% indicative pricing range.
At its issue/fixed re-offer price of 99.50 the bond offered a headline-grabbing 1,200bp pick-up over Bunds and combined with the transaction's optically attractive 16% coupon - the highest ever in the Euro-DM market - it proved an irresistible lure for many investors.
In terms of regional comparisons, the B2 rated Ukraine issue offered a 700bp-plus margin over the then Ba2/BB- rated Russian Federation's DM2bn 9% March 2004 transaction, which was trading at 475bp over German government bonds.
On the back of the strong investor bid for the paper, the issue broke syndicate at 100.50 and, by the end of the first week's trading, was just off its highs at 101.25 bid, 101.75 offered, having touched 101.5/102 at one point.
While investors proved keen fans of the deal's pricing, some market participants expressed reservations about the issue. "Bunds plus 12% smacks of desperation to me," commented one syndicate member, who felt that, by paying such a high price, Ukraine had sent out the wrong message about the state of its economy.
The lead managers pointed out, however, that the deal made sound economic sense for Ukraine. "The all-in cost of funds for the borrower was just 16.2% - around half what the Ukrainian government is paying domestically in foreign currency terms for much shorter term money," countered a Merrill Lynch spokesman.
The leads were also quick to refute claims that the bulk of the issue had been placed with retail investors who had been blinded to the underlying risks involved in the transaction by the 16% coupon.
"In terms of distribution, this was very much an institutional play as far as the leads' primary market placement was concerned," said the Merrill official. "Less than 5% of our bonds went directly to retail - which was a deliberate policy, as we didn't want to sell paper to anyone who didn't understand the risks."
He added that Commerzbank and Merrill Lynch had placed paper with over 300 institutions, both specialist emerging market accounts and more generalist investors, many of which were buying Ukrainian risk for the first time.
In addition to the expected placement into Germany the leads also sold bonds to investors in Austria, the Benelux, France, Italy, Switzerland and the UK, as well as to offshore US accounts.
In the light of the failure of the country's planned dollar issue, the blow-out reception to the maiden Euro-DM transaction represented a vindication of Commerzbank and Merrill Lynch's marketing approach to the issue - and also provided a timely boost for a Ukrainian government facing a testing general election at the end of March.
A government spokesman observed at the time: "The pricing was important to us and we expect that, as investors shake off Asia-related concerns, growing investor demand will lead to increasingly better terms for future issues by Ukraine.
"However, our overriding objective with this issue was to achieve overwhelming success, secure an outlet for future access to the Deutschmark sector and cultivate a loyal following for Ukraine among the world's largest institutional investors."
Having targeted the Deutschmark, the most important of the current European currencies, the Ukrainians' attention quickly shifted to the future leading European currency, the euro.
In early March, Ukraine became the first central and eastern European issuer to tap the euro market, launching a Eu500m two year offering.
Lead managed by SBC Warburg Dillon Read, the transaction was roadshowed at an indicated issue size of Eu200m-Eu400m. But the investor demand for name and credit diversification as well as yield - which has re-emerged since the Asian crisis - allowed the lead manager to increase the transaction to Eu500m.
The issue featured a 14.75% headline coupon to yield 15.06%, or 1,084bp, over the 9.25% April 2000 OAT at the re-offer price of 99.50.
This represented the highest ever coupon and launch spread in the fast growing single European currency bond sector and was well above the levels offered by the other emerging markets sovereigns which have launched euro issues - Ba3/BB rated Argentina (8.75% coupon, 359bp launch spread), B1/BB-
rated Brazil (8.625% coupon, 390bp launch spread) and Ba2/BB rated Mexico (7.625% coupon, 230bp launch spread).
Furthermore, at the equivalent of 1,070bp over Deutschmark Libor, the euro issue offered a 100bp pick-up over the 970bp trading level of Ukraine's Deutschmark bond.
That issue had traded up strongly to 104.75 bid, 105.25 offered from its issue/fixed re-offer price of 99.50 and provided an encouraging backdrop for the euro issue.
SBC Warburg's distribution was split 30% UK, 20% Italy, 20% Switzerland, 10% Germany, with the 20% balance going to other European countries and the Middle East. Some 70% of its primary market placement was said to have been to institutional accounts.
Ultimately, however, the stellar performance of the Deutschmark transaction built up expectations among some institutions that the euro deal would perform equally well at launch.
When it failed to price up at the break of syndicate, some professional buyers dumped their bonds back in the market. As a result, by the end of the first week's trading the euro issue traded down to 98.50 bid, 99.75.
An SBC Warburg spokesman said: "The problem was that a number of institutions expected the deal to price up a couple of points at the break - which we think was unrealistic - and they didn't have the patience to wait for the retail bid to kick in."
While some syndicate members agreed that there had been strong demand for paper, several claimed that the lead had failed to attract high quality buy-and-hold investors, which had led to the deal's poor trading performance.
By the time Ukraine returned to the Euromarkets with a DM250m fungible increase to its DM750m three year issue in late April, the political landscape in Ukraine had veered to the left, following parliamentary elections at the end of March.
The add-on was once again lead managed by Commerzbank and Merrill Lynch and featured the same 16% coupon as the original issue, but had a higher issue/fixed re-offer price of 102 to give a yield of 15.1% and a 1,000bp spread - in line with the trading spread on the country's euro transaction.
The reception from Deutschmark investors was equally enthusiastic the second time and provided ample proof that, if issuers are prepared to pay eye-catching coupons and spreads, they are virtually assured Euromarket access.
Encouraged by the sovereign's ability to tap the international bond markets, a number of Ukrainian municipal and regional credits are already mulling debut offerings.
The port city of Odessa has already secured a B+ rating in preparation for a DM100m issue via Dresdner Kleinwort Benson, while L'vov has mandated Bank Austria Creditanstalt for a $50m transaction.
The cities of Kiev, Donetsk, Kharkov and Sevastapol are also studying the possibility of Euromarket issues. And the Crimea region has mandated Commerzbank for a DM100m issue.
Whether Ukraine can continue to maintain its position in the international bond market and attract new investors in the future will depend heavily on whether the country can deliver on long promised economic reforms.
Despite its reputation as a reform laggard, Ukraine can nevertheless point to a number of important positives in its recent economic performance.
An end to the country's transition recession is in sight, with output set to stabilise this year and grow by up to 3% in 1999.
Inflation, which reached a hyperinflationary 10,000% in 1993, has been slashed to under 10%, and the current account balance is forecast to remain at a manageable 3.2% this year.
Set against that is Ukraine's lamentable record on privatisation, which has been fiercely resisted by anti-reform factions in the left wing dominated parliament, and which resulted in Ukraine attracting less than $36m from state sell-offs last year.
As a result, Ukraine - with a population of 50m - has only attracted foreign direct investment totalling $2bn since independence, compared to Hungary, which has attracted $15.6bn with a population of 10m.
If, however, president Leonid Kuchma can push through the reforms demanded by important donors such as the EU and the IMF, then 1998 may be the year in which Ukraine turns an all-important economic corner. EW