Ukraine in pain but China is real danger

Ukraine has a long history of weak credit quality. Indeed, one has to go all the way back to August 2011 to find 5-year CDS levels tighter than 500bps.

But the country's situation has taken a turn for the worse in recent weeks due to an often overlooked element in investing: political risk. Ukraine's spreads hit 1,325bps on February 19 - the widest level for more than four years - as the country seemed to be spiralling towards civil war. However, they soon recovered to dip below 1,000bps after the intransigent President Yanukovych - whose actions helped trigger the turmoil - was removed from office.

Ukraine's problems are far from solved and, as such, its spreads are likely to remain highly volatile for the foreseeable future. The uncertainty is reflected in the shape of the sovereign's credit curve. Until September 2013 Ukraine's curve was the normal, positive shape. But it subsequently started to invert, and by the end of February the one-year was trading in excess of 1,000bp wider than the five-year. This inversion is a typical sign of credit distress. A curve flattening strategy would have been profitable over this period, though it should be noted that the one-year tenor is significantly less liquid than the five-year and this could prevent the trade from being implemented.

The fragile political climate in Ukraine will probably ensure that the future direction of the sovereign's spreads will take several twists and turns. The IMF is due to arrive in Kiev in the coming days, and its assistance will be necessary for Ukraine to avoid default. The government has said it needs $35bn over the next two years, and it will no doubt receive some funds from the IMF. Undoubtedly there will be conditions attached, and it is unknown whether the Washington fund will insist on a debt restructuring.

From a CDS perspective, the crucial aspect will be whether the restructuring is forced; if not, then it probably won't trigger a credit event. The austerity that the IMF normally prescribes could make life difficult for the new pro-western government and force the country back into the arms of Russia - a prospect that would surely result in further conflict.

Ukraine's travails had little impact on the broader credit market, with most investors viewing it as an idiosyncratic event. China is of far more systemic importance, and it was interesting to see that the sovereign's outstanding amount of CDS net notional rose sharply to $11.1bn last week (DTCC). Leading indicators, such as the HSBC/Markit PMI, will continue to move markets, though the condition of China's shadow banking system is arguably even more crucial.

Download full article