Emerging Markets: How To Invest In Ukraine?

by: Andrii Taranukha

Investors try to avoid near-zero or negative interest rates currently offered by developed markets. Emerging Markets provide a high yield but have significant risks.

Ukraine is relatively new in the investment arena and can provide unique investment opportunities with high payoffs.

Investors can choose between the direct or the indirect investment that differs in degree of risk, return, and expenses.

Most of the investors focus on the Emerging Market countries such as China, Brazil, India, South Korea and Mexico. Investors tend to overlook investment opportunities in countries experiencing short-term political and economic instability. But when uncertainty is high, a relatively inexpensive investment may yield significant payoffs in the long run.

Is it reasonable to consider investing in Ukraine at this time?

Investing in Ukraine at the current time may seem too risky because of its uncertain future especially in light of possible Russian invasions and questions about the sustainability of economic reforms enacted by the new government. There are, however, other points to consider.

1. On September 1, Ukraine paid $500mm of interest payments, one year from the landmark debt restructuring. The next payment is scheduled for March 1, 2017.

2. Credit default spreads tightened to 1251bps from around 4,000bps, while the probability of default decreased to 17.7% from 38% in one year. Nevertheless, the likelihood of the default based on the Bloomberg model, considering current economic and political conditions, is still quite high: markets ask 661bps for 5-year protection.

Source: Bloomberg Terminal

3. As of November 19, 2015, Moody's upgraded Ukraine's credit rating to Caa3 from Ca. Caa3 is the most conservative rating out of the three nationally-recognized statistical rating agencies. Moody's affirmed this credit rating because of the stable outlook based on a recent quarterly review. This stable outlook indicates a small likelihood of rating change in the medium term.

4. Ukraine is waiting for the $1.7 billion tranche of the $17.5 billion restructuring program. The IMF scheduled a committee meeting for September 14, 2016 to vote for the release of the loan. Recently, IMF spokesman Gerry Rice informed Reuters that Ukraine is very close to receiving new financing. New credit will decrease market volatility and ease the pressure on the national currency. This will put Ukraine on the stable path of economic recovery.

5. Ukraine will issue a 5-year $1 billion Eurobond under the USA guarantee. This is the third warranty received from the Government of the USA. The previous two guarantees granted in 2014 and 2015 allowed Ukraine to obtain $2 billion in the international capital markets at a record low interest rate.

What are the options for the potential investors in Ukraine?

  • Direct Investment

The Ukrainian bond universe consists of corporate and sovereign bonds. Investment in corporate debt requires the highest level of expertise because of the complexity of local businesses and laws. In addition to the significant probabilities of default, some bonds pay interests in the form of local currency. These will complicate the fair valuation of the securities.

Sovereign bonds are less likely to default and pay interest in US dollars, which eliminates currency risk. Eurodollar bonds are a sound investment for the individual investor who wants to have exposure to Ukrainian debt. Eurodollar bonds pay 7.75% and offer maturities between three and nine years. All issues trade around par, and Ukraine has been rated B- by S&P, CCC by Fitch, and Caa3 by Moody's.

Does this mean that bonds with the same credit rating have the same level of risk?

While credit rating is a reliable estimate of the Obligor's creditworthiness, it is not an appropriate standalone risk measurement tool. For example, Moody's granted Caa3 with a negative outlook to the Government of Venezuela.

A negative outlook means that the rating agency expects to downgrade the country's rating in the medium term. Forty-five percent of Venezuela's revenues depend on the export of natural resources: oil and gas account for 90% of exports and 32% of GDP.

As exports are dependent on international commodity prices, this might be a more significant factor affecting a country's probability of defaulting rather than the credit rating.

What should investors keep in mind when they are measuring a country's risk?

An investor should understand country-specific, or unsystematic, risk: Uncertainty about possible further Russian invasion and price of oil cause short-term volatility for Ukrainian and Venezuelan debt. Investors will have a significant return if they bet against short-term volatility.

Considering the current situation, a standalone investment in Ukrainian debt carries a high degree of risk. Apart from systematic risk, the investor bears country-specific risks. In addition, investors are rewarded only for systematic risks. Portfolio diversification is expected to decrease country-specific (unsystematic) risk.

An investor should consider consulting with a highly-experienced Advisor on Emerging Markets who will construct an individual portfolio based on the risk and return objectives of the investor. A diversified portfolio will enable the investor to hedge the negative impact of country-specific risks.

  • Indirect investment

Creating individually-tailored portfolios can be expensive. As an alternative, an investor can buy shares of funds that are managed by investment professionals with extensive experience. Portfolio managers use different strategies which depend on the type of investment vehicle. These strategies are discussed below.

1. Passive Investment Strategy

An ETF is an example of a passive investment strategy that tracks a pre-determined index. As an example, I will take two ETFs that have exposure to Ukrainian debt.

The Vanguard Emerging Markets Government Bond ETF (NASDAQ:VWOB) attempts to replicate the performance of the Barclays USD Emerging Markets Government RIC Capped Index.

The ETF invested $13.45 million (1.4%) out of $961 million AUM in Ukrainian debt. The fund focuses on short- and medium-term investments (up to 10 years), 77.8% of which are high yield bonds.

The SEC yield is 4.07% and shares trade close to the high of its 52-week range ($72.13-$80.08). Since interception, the fund returned 5.29% and beat the benchmark by 10bps on average.

Despite excellent performance and diversification, a tiny concentration of Ukrainian debt limits the potential advantages of investing in Ukraine. An investor looking for exposure to Ukrainian debt should not consider this fund.

The iShares JP Morgan USD Emerging Markets Bond ETF (NASDAQ:EMB) attempts to replicate the JP Morgan EMBI Global Core Index benchmark. The ETF invested $295 million (2.96%) out of $9,900 million AUM in Ukrainian debt. Ukraine is the 15th largest Obligor in the portfolio. The fund focuses on medium-term investments (5-10 years), 56.67% of which are investment grade bonds.

The SEC yield is 4.33% and shares trade close to the high of its 52-week range ($102.90-$118.14). Since interception, the fund returned 6.70% and underperformed the benchmark by 90bps on average.

The fund offers significant exposure to Ukrainian debt with proper diversification. The portfolio management team follows the index and allocates almost the same weight to the assets, while selecting securities from the index universe. Security selection can explain the performance of the fund compared to the benchmark.

I believe that investors should consider an active management strategy, which is not limited to the asset allocation of the benchmark, rather than a passive investment strategy. Portfolio managers can overweight or underweight the benchmark based on their market view and expectations. Custom asset allocation and security selection allow portfolio managers to explore market inefficiencies and increase upside potential.

2. Active Investment Strategy

To explain an active investment strategy, I will take a sample from 2 mutual funds that have exposure to the Ukrainian debt.

Templeton Global Total Return Fund (MUTF:TGTRX). Michael Hasenstab manages this fund and makes unpopular investment decisions. Nevertheless, he was able to make €5.6 billion on the Irish deal in 2011 at the height of the financial crisis. Hasenstab is the first portfolio manager who made a contradictory bet on Ukrainian debt in 2013.

Currently, the fund holds $272 million (5.12%) out of the $5,300 million AUM and focuses on short-term investments (up to 5 years), 63.51% of which are investment grade bonds. Ukraine is the 5th largest Obligor in the portfolio.

The SEC yield is 5.14% and shares trade close to the high of 52-week range ($10.59-$11.93). Since interception, the fund returned 6.97% and outperformed the benchmark (Bloomberg Barclays Multiverse Index) by 281bps on average.

Fidelity New Markets Income Fund (MUTF:FNMIX). Currently, the fund holds $190 million (3.90%) out of the $4,900 million AUM and focuses on short- and medium-term (up to 10 years) investments, 68.58% of which are high yield bonds. Ukraine is the 9th largest Obligor in the portfolio.

The SEC yield is 5.14% and shares trade close to the high of 52-week range ($13.95-$16.43). Since interception, the fund returned 10.95% on average and outperformed the benchmark (JP Morgan EMBI Global Core Index) by 345bps on average.

Source: Bloomberg Terminal

What is the difference between the performances of the mutual funds?

The difference in performance of the mutual funds depends on asset allocation and security selection. I have compared asset allocation of two mutual funds based on the JP Morgan EMBI Global Core Index.

  • Asset Allocation.

Source: Author, data from Franklin Templeton and Fidelity Investments websites

  • Security Selection

Source: Bloomberg Terminal

Source: Bloomberg Terminal

Here is the bottom line.

  • Direct investment provides the opportunity to create a personal investment strategy based on the individual needs and objectives of the investor.
  • This approach requires a high level of expertise in Ukrainian markets and portfolio construction. Direct investment has the highest payoff, but it can also be expensive.
  • An alternative option is to invest indirectly in investment vehicles that apply either passive or active investment strategy.
  • The passive investment strategy follows the weights of the benchmark and limits the upside potential on Ukrainian debt.
  • The active investment strategy focuses on custom asset allocation and security selection based on the market view and expectations of the portfolio managers. The portfolio manager can react efficiently to any positive or negative news, and will be able to underweight or overweight assets as necessary.
  • The funds have a different asset allocation and security selection. More research into the performance of particular asset classes and individual securities will help identify the difference between the overall performance of the fund and the benchmark.
  • An investor should choose the mutual fund based on the investment style of the portfolio management team, specifically:
  1. Asset allocation,
  2. security selection,
  3. the overall performance of the fund, and
  4. fees and expenses.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.