Ukraine's Troubles Hit Bonds

Credit-Rating Downgrade Weighs on Country's Debt Market

By SERENA RUFFONI Ukraine's government bonds tumbled to fresh lows Tuesday, narrowing the cash-poor country's options for financing its debt and its spending, and pushing it closer to a bailout from the International Monetary Fund. The ex-Soviet republic has a litany of problems: a wide budget deficit, a wider trade deficit, dwindling reserves of foreign currency and debt coming due that needs to be repaid with it. And recent trading in Ukrainian bonds suggests that it will be prohibitively expensive for the government to raise fresh funds from capital markets anytime soon. On Tuesday, a 10-year dollar-denominated government bond hit a yield of about 10.5%, according to Tradeweb, up from 9.64% on Monday. That bond yielded around 7.5% when it was issued in April. Yields rise when prices fall. Yields on Ukrainian debt have moved even higher on short-term bondsa warning signal that investors are deeply concerned. "Ukraine is one of the emerging-market countries in [the] worst shape," said Viktor Szabo, a fund manager at Aberdeen Asset Management in London. "The price action is only catching up now with the deterioration of the country's fundamentals." Mr. Szabo, who doesn't hold Ukrainian government bonds, added: "Ukraine will find it very difficult to access foreign debt markets now." Providing a backdrop to the country's plight is a soured relationship with Russia. Ukraine is a major transit point for Russian natural gas headed to Europe, and Ukraine also needs gas to power its industry. Ukraine has long pressed Russia for cheaper gas supplies, saying high prices cripple its economy. Russia wants Ukraine to enter a customs union in exchange for a discount. Ukraine wants to ink a trade deal with the European Union instead. Enlarge Image Ukraine's wide budget deficit and other problems have hurt its bonds. Here, its central-bank building in Kiev. Time appears short, and investors fear that Ukraine will face a cash crunch in coming months. Ukraine's international reserves are steadily sliding, to $21.7 billion as of Sept. 1. That is enough to cover only a few months of imports. Meanwhile, prices for the country's main metals and chemicals exports have slid while the cost of key Russian gas imports has risen. Through the end of 2014, Ukraine's government must pay about $10.8 billion to service foreigncurrency-denominated debt, including interest payments, according to Moody's Investors Service. But as of July, Ukraine had only $1.8 billion in cash in its coffers, according to Moody's, which late Friday

downgraded Ukraine to Caa1deep in "junk" territory. The government is running a budget deficit of about 5% of economic output. "The red flags have been flying for some time in Ukraine," said Tim Ash, head of emerging-markets strategy at Standard Bank. Still, many investors have been lured by the fat yields the bonds pay in exchange for the risk. Ukraine is a huge producer of crops, especially wheat, and it has strengthened economic ties with the EU. Franklin Templeton allocated 3.46% of its $70 billion Global Bond fund to Ukraine, as of June 30, according to a fund document. A Franklin Templeton spokeswoman declined to comment. Ukraine's next move isn't clear. The government has made ad-hoc borrowings, including a $750 million loan from Russia's Sberbank last week. Daniel Vernazza, an emerging-markets economist at UniCredit, reckons that Ukraine will need aid by the middle of 2014 at the latest. He says Ukraine is most likely to sign the trade deal with the EU, then ask the IMF for helpthough a Russia deal also is possible, he says. Mr. Vernazza says Ukraine has tried to keep both options open"but it is evident these choices are mutually exclusive." Ukraine's last IMF lending program was frozen in 2011 after the government refused to increase household gas prices, which it heavily subsidizes. In an interview broadcast Monday with Russian state news channel Rossia 24, Ukrainian Prime Minister Mykola Azarov said he hoped the IMF would change its conditions for new lendingadding that he "can't place the burden of unjustified gas prices" on the public. "The world is large. If we don't reach an agreement with the IMF, we'll take [loans] elsewhere," Mr. Azarov said, without elaborating. In a briefing earlier this month, an IMF spokesman said the fund has had "periodic discussions" with Ukraine at a "technical level," but that no in-depth discussions had taken place with policy makers. James Marson, Katya Gorchinskaya, Ian Talley and Katie Martin contributed to this article. Corrections & Amplifications An earlier version of this story said Ukraine had $10 billion in external debt repayments in the next year. According to Moody's Investors Service, it has $10.8 billion in foreign-currency-denominated debt service, including interest, due through the end of 2014. The story also said Ukraine has been selling dollars persistently to support the local currency. While the country's reserves have been declining, data indicate the central bank last intervened on the foreign-exchange market to sell dollars in March. A version of this article appeared September 25, 2013, on page C1 in the U.S. edition of The Wall Street Journal, with the headline: Ukraine Troubles Hit Bonds.