Sujata Rao

Two years after a landmark debt restructuring, Ukraine is seeking a bond swap to avoid a mass of near-term repayments. But its real problem may lie further out - when securities linked to economic recovery start falling due.

Ukraine threw in $3.6 billion in GDP warrants - bonds indexed to economic growth - to sweeten its 2015 restructuring that forced investors to write off 20 percent of the original value of their holdings.

But Kiev made one crucial omission: unlike other warrant issuers, it did not cap future payouts, possibly making itself liable for big annual payments after 2025.

The warrants pay no regular interest but they kick in once Ukraine’s nominal GDP exceeds $125.4 billion and annual growth hits 3 percent. Payouts are subject to a complex formula but, put very simply, holders are entitled to a sum equal to 15 percent of any economic output achieved above this growth threshold, adjusted for inflation.

Should the economy expand 4 percent or more, holders will take away no less than 40 percent of national wealth created above that higher level. FACTBOX:

Annual interest payouts cannot exceed 1 percent of GDP until 2025 but after that, until expiry in 2040, there is no upper limit.

“If you take a positive view of Ukraine in the long term, this is where you want to be. But for the government, this may be a high contingent liability going forward,” said Kaan Nazli, senior economist for emerging debt at Neuberger Berman, an asset manager which holds the warrants.

Back in 2015, Ukraine was deep in recession and 3-4 percent growth seemed a distant prospect. Even now, with the country still in conflict with Russia, it is impossible to predict what future payouts may look like.

To illustrate what Ukraine might face, Nazli calculates a $120 million payout in 2021 in a scenario where 2019 growth is 3.5 percent, leaping to $1.6 billion if growth hits 6 percent. Without the payout cap that is effective between 2021 and 2025, the bill would have been $2 billion, he says, predicting Ukraine would instead buy back the warrants “to reduce the burden for future generations”.

Finance Minister Oleksandr Danylyuk told Reuters that “as part of our liability exercise, we can look at warrants at some point” but declined to comment further. He was on a roadshow to market new dollar debt and persuade investors to swap bonds maturing in 2019 and 2020 for longer-dated ones.

Nazli, however, described Ukraine as “a bit stuck”. With recent data showing the economy slowly recovering, the warrants’ price has almost doubled this year to 60 cents in the dollar. Buying them back now would cost Kiev over $1.6 billion.

Ukrainian institutions give differing figures for GDP growth but the payouts depend mostly on International Monetary Fund data. In its latest World Economic Outlook, the IMF forecasts growth at two percent this year, rising to four percent in 2020.

Danylyuk estimated the economy’s current size at $95 billion, well under the payout threshold.

But BlueBay strategist Tim Ash says Kiev must prioritise buybacks, adding that Ukraine could well emulate central European economies such as Poland’s which achieved 4-5 percent annual growth for years as they recovered from economic collapse after the fall of Communism in 1989.

“I argued the structure (of the warrants) was inappropriate for Ukraine and I think this is now showing effect ... (Buyback cost) is only set to rise, and potentially quickly,” Ash added.

GDP warrants have been used in other debt restructurings, notably by Argentina in 2005 and Greece in 2012. Countries such as Nigeria and Venezuela have also offered oil warrants which paid out in event of an energy price windfall.

The idea is to give a country breathing space, allowing it to pay less during an economic slump. Investors may accept restructuring terms which are less onerous to the borrower if promised a slice of future growth.

A 2006 IMF study advised though that “all (warrant) payments are capped to ensure that in the event of extreme growth surprises, cash-flow payments do not exceed the country’s capacity to service debt”.

Greece capped warrant coupons at 1 percent of the notional amount. Argentine payouts could not exceed 48 percent of the warrant’s face value. Nigerian warrants were triggered at a $28-per-barrel crude price but stopped paying above $43 a barrel.

In Ukraine’s defence, it went into the restructuring with a disadvantage - around 40 percent of outstanding bonds were held by Franklin Templeton. The asset manager held a majority in many of the issues, allowing it to block the restructuring until it got terms that satisfied it.

People familiar with the talks said “concentration of power” with Templeton fund manager Michael Hasenstab had left Ukraine with few options if it was to avoid outright default.

Martin Gudgeon, head of European Restructuring at PJT Partners, the firm which represented the creditors in the negotiations, noted Ukraine had asked creditors to write off 40 percent of the bonds’ value but eventually agreed to provide an equity-like instrument in return for the 20 percent writedown.

“We came up with it to find a solution for our clients,” Gudgeon told Reuters. “The uncapped GDP warrants look like a pretty good deal now.”

Hasenstab clearly sees value in the warrants. He has cut Ukraine exposure this year to under 2 percent of total net assets of his flagship Global Bond Fund, down from 4.7 percent at the end of 2016. But the warrants’ share in the fund is unchanged at 0.64 percent, with a $650 million face value.

Various other Templeton funds also own the warrants.

Holders of Argentine warrants found they were not without risk - the country dodged payments by publishing data that was widely considered as understating growth. Ukraine would find that harder as its performance is largely measured by IMF data.

But fighting with pro-Russian separatists in eastern Ukraine and a slow pace of reform could well brake recovery, meaning investors who wrote off a fifth of the bonds’ value during restructuring must wait longer to recoup their money. Or they may never do so.

Gabriele Foa, EEMEA cross-asset strategist at Bank of America Merrill Lynch estimates Ukraine’s potential growth at 3.0-3.5 percent and assesses fair value for the warrants in the low 50s of cents per dollar face value. “At these (price) levels I would be sceptical about the fundamental value left in these instruments,” Foa said.

There is a wide range of views though. JPMorgan analyst Jonny Goulden assigns a value of 93 cents, citing Ukraine’s improving growth, inflation and exchange rate picture.

In a mid-August note, he predicted Ukraine’s nominal GDP would exceed $125 billion in 2019 and that payouts could start in 2021, instead of 2024 as he had forecast earlier.

“This makes cashflows likely to happen earlier and therefore total cashflows will be higher over the life of the warrant,” Goulden wrote, advising clients to hold on to the securities.-Reuters