Stay Away From Ukrainian Debt - It's Cheap For a Reason

I've been asked many times recently if I would buy Ukrainian bonds now.  The short answer is ‘no’.  This story is far from over.

There are multiple scenarios that could play out in Ukraine that would be detrimental to bond holders and the risk of an eventual restructuring is simply too high. To fully understand the situation, one has to take a quick tour through history.

Ukraine is the old kingdom of Kievan Rus; it's where Slavic civilization started.  Ukraine, Belarus, and Russia all come originally from Kiev.  In the thirteenth century, when the Mongols invaded, occupied, and destroyed this region, the Slavic princes moved to Moscow to escape the invasion – and Russia was born.

The bottom line is Russia can legitimately lay claim to a historic tie to the region.  Russia also has a large Black Sea fleet at Sevastopal on the Crimean Peninsula.  What happens to Ukraine is definitely in Russia's national interest.  One probable scenario is that President Vladimir Putin will occupy and control the Crimean Peninsula by force to protect the Russian naval base and the Russian speaking people who dominate the eastern part of the country.

The United States and the EU seem to be ignoring the desires of a large portion of Ukrainian territory that would love to be under Russian control.  Putin has repeatedly spoken of Ukraine as a vassal rather than a free and independent state.  Another possible end result is a divided country.  The pro-Western opposition, which used to be controlled by Poland back in the day, could easily form an alliance with the EU and NATO.  The eastern pro-Russian population could easily go the opposite direction.

The pressing issue for the Ukraine currently is short-term sovereign and gas debt that matures in 2014. To satisfy these and other payments, Ukraine needs approximately $19 billion.  Over the next two years it needs $35 billion.  Russia had promised $15 billion but cut off payments after fugitive president Viktor Yanukovych, an ally of Moscow, was removed from power.

What resources does Ukraine have to raise cash to self-fund its debt service in the future?

Hydrocarbons.  Oil and natural gas have been its saving grace and its downfall.  The territory is blessed with an abundance of hydrocarbon deposits on and off shore.  The problem is the Soviet legacy of corruption has prevented the fruits of these resources from reaching the Ukrainian people.  This is the crux of the demonstrations that have been playing out on national television.  Yes, Ukraine needs money, but what it really needs is to systematically weed out corruption from its oil and gas industry.  Billions are siphoned off every year from the transmission of gas through Ukraine that end up in the pockets of shadowy figures and oligarchs.  There is no easy or short-term fix to this problem.

Now that the opposition has removed Yanukovych and parliament has installed an interim president, western powers are considering a $35 billion aid package for the beleaguered country.  If this package is dispersed, yes there will be a bounce in Ukrainian bond prices.  That is IF Yanukovych is really out of power.

There are two issues with an IMF bailout.  The first is whether or not it will happen at all.  The provision of aid is probable based on austere conditions.  It is not probable that the Ukraine will accept these conditions.  Second, if it does happen, how will the West ensure it is not stolen through the corruption that exists today?  It will take years to remove a corrupt influence over the oil and gas sector.  It will take years for the rule of law to emerge in Ukraine.  And the big question is, will Russia allow it to happen.

The opposition in Ukraine wants to have a free country that is open to the West.  The question is whether or not they will do what is needed to achieve this outcome or will another regime take the last one's place on its way to raping the country?  The powers that be in Ukraine have their own interests at heart, not the welfare of the Ukrainian people.  So my advice is, find another place to find yield.  Here the risk is just too great in the short and long term.

L. Todd Wood is a former special operations helicopter pilot, bond trader, and contributes to The Moscow Times.  Now he writes historical fiction novels.