Ukraine faces key test on debt freeze plan in bid to avoid messy default

Ukraine‘s creditors vote this week on a government proposal to defer payments on the war-torn country’s international bonds for 24 months as Kyiv hopes to swerve a $20 billion messy default.

Bondholders have until 5 p.m. New York time (2100 GMT) on Tuesday to decide whether to back or vote down the proposal by Ukraine‘s government, which faces a $5 billion monthly financing gap and liquidity pressures following Russia’s invasion on Feb. 24. Time is precious: the country has a $1 billion bond maturing on Sept. 1.

Creditors will likely wait until relatively close to the deadline to vote, said a person familiar with Ukraines thinking. Investors are expected to support the debt standstill, the person added.

When announcing its proposal, Ukraine‘s finance minister Sergii Marchenko said it had “explicit indications of support” from some of the world’s biggest investment funds including BlackRock, Fidelity, Amia Capital and Gemsstock.

Creditors of Ukravtodor and Ukrenergo, two state-owned firms that have government guarantees on their debt, also have until Aug. 9 to vote on a plan similar to the sovereign.

Is this a default？

The two-year moratorium on external debt payments would allow Ukraine to avoid a contractual or legal default, as any amendment on the bonds‘ terms would have the creditors’ backing, Rodrigo Olivares-Caminal, professor of banking and finance law, at Queen Mary University of London, told Reuters.

However, creditors could ask whether a default insurance known as credit default swaps (CDS) should kick in, as a deferral of payments might be considered a credit event by the International Swaps and Derivatives Association (ISDA).

Investors are sitting on about $221 million of insurance on Ukraines debt, according to Depository Trust & Clearing Corporation (DTCC) data on the CDS.

Credit rating agencies might also classify this as a “selective default” or “default”.

“A contractual default, a credit event and a credit rating default are three different albeit related concepts,” Olivares-Caminal said. “Incurring any of the three doesnt mean that the other two will trigger.”

While investors are expected to back the freeze it is unclear whether the country may still need a debt restructuring in the medium term.

“It is just a pause button – we do not know what shape Ukraine will be in in a few months or a few years down the line,” said Luis Peixoto, emerging markets economist at BNP Paribas in London. “Investors are already preparing for a debt restructuring.”

The dollar-denominated bonds trade at deeply distressed, some as low as 17 cents in the dollar.

Battered by the war, which Russia calls a “special military operation”, Ukraine faces a 35%-45% economic contraction in 2022, according to estimates from the government and analysts, and is heavily reliant on foreign financing from its Western partners.

Ukraine aims to strike a deal for a $15 billion-$20 billion programme with the International Monetary Fund before the end of the year.

Ukraine restructured its debt in 2015 after an economic crisis linked to a Russia-backed insurgency in its industrial east. The deal left it with a large number of payments due annually between 2019 and 2027, and it returned to international markets in 2017 with a $3 billion hard-currency debt issuance.

For the foreign debt freeze plan to be successful, the so-called consent solicitation requires the support of investors holding two-thirds across the 13 Eurobonds maturing from 2022 to 2033, and at least 50% of the holders of each note.

The government launched a separate proposal on its $2.6 billion of outstanding GDP warrants, a derivative security that triggers payments linked to its economic growth.

In late July, Ukraine‘s state-energy firm Naftogaz became the first Ukrainian government entity to default since the start of the Russian invasion. Naftogaz’s bonds are not guaranteed by the sovereign.