Ukraine GDP warrants have had a bad couple of days, with the price falling 6% since 11 November. Prices are now indicated at cUS$98 (mid) on Bloomberg, their lowest for 12 months (almost to the day), although, in truth, the warrants have been drifting down for some time. They are 20pts (17%) down from their peak this year, in June.
Indeed, the warrants have seen a total return so far this year of -4.7%, compared with -3.7% for the UKRAIN 7.375% 2032s, and -1.6% on the Bloomberg EM Aggregate Index (according to Bloomberg calculations). Since September, their underperformance is even starker, at -14.1% compared with -5.7% on the bond and -2.2% on the index.
What has happened?
We highlight two things.
First, reports over recent weeks of a Russian troop build-up on the Ukrainian border, again (although they never really went away). Although full-scale invasion seems unlikely (surely), it has provoked alarm from the US, the EU and NATO nonetheless. Of course, we've been here before, most recently, this spring, but the situation quickly de-escalated back then. The same may be hoped this time around, but the motives for this recent escalation are not so clear. Some reasons may be broadly the same (Putin seeking to keep Ukraine weak and reflecting Moscow's dissatisfaction with President Zelensky's fight against pro-Russian interests), while others (such as testing a new Biden administration and Russia's Duma elections) are now behind us.
Second, downward revisions to Ukraine's growth outlook, with expectations for real GDP growth this year falling from above 4% at the beginning of the year, to closer to 3%, and we suspect downside risk to that too (and the design of the warrants means that payments are pretty small between 3-4% growth, but accelerate if growth is above 4%). And while the Bloomberg consensus remains at 3.8%, this is sure to come down. The National Bank of Ukraine (NBU) now projects growth of 3.1% this year (in its October Inflation Report), down from 3.8% in July.
Although real GDP for Q3 released yesterday showed the economy exiting technical recession, with growth of 1.4% qoq (sa), the annual rate was below expectation, at 2.4% yoy, compared with the consensus of 3.6%, and well down from 5.7% in Q2. The annual rate was also well below the 4% projected by the NBU (the NBU also projects 4.3% growth in Q4). It means growth in the first three quarters is running at 2% yoy. Growth would have to be 6% yoy in Q4 to generate full-year growth in excess of the 3% baseline trigger for a payment on the warrants, which seems unlikely with the central bank monetary tightening and domestic Covid infections having been on the rise.
Hence, prospects for another payment on the warrants any time soon are diminishing, and the next payment may not be until 2024. After the small US$1.258 per US$100 payment this year (and the first payment since they were issued in 2015), there will be no payment next year anyway based on last year's growth and prospects for a payment in 2023, based on this year's growth, seem to be disappearing. Hence, the warrants are probably adjusting to the prospect of the next payment not being until 2024, based on next year's growth. The NBU projects real GDP growth of 3.8% in 2022.
The warrants' price action may also be removing a bit of froth. After the Covid-induced recession last year, investors in the warrants quickly began to look through 2020 to anticipate a sharp V-shaped recovery in 2021, and a mega payment in 2023, even if something of a one-off. This hasn't happened. And if there was ever potential for +4% growth in the near term, you'd have thought it would be now. Instead, the lingering concern for investors now is whether Ukraine can break above 3% growth, let alone 4%, on a sustained basis.
On a positive note, but washed out by the events above, the IMF has scheduled the board meeting for the long-delayed first review of the SBA on 22 November. This follows staff-level agreement on 18 October.
We retain our Buy on the GDP warrants, taking a longer-term view on Ukraine's growth prospects. Our model-derived fair value for the warrants (unchanged from our last update in May) is US$166, assuming a conservative 3% trend growth in real GDP, low growth volatility (3% standard deviation) and a cautious 10% discount rate, and after applying a 25% model discount. Our fair value estimate falls to US$119 under a more cautious 2.5% trend rate of growth. See here for more detail.
We retain our Hold recommendation on the US$ bonds, with a yield of 7.4% (z-spread 606bps) on the 2032s on a mid-price basis as of cob 15 November on Bloomberg. Yields have risen 50bps since the last 10 November (prices down 4pts), most likely due to the Russia border situation, and are up 110bps since the September sell-off.