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A Solution to the Ukraine-Russia Bond Stand-Off Adam Lerrick Ukraine and Russia are at a stalemate over the US$ 3 billion bonds due in December 2015 that were purchased by the Russian government in 2013. Russia believes the bonds are an official concessional loan that should receive preferential treatment in any debt restructuring. Ukraine claims the bonds are a commercial investment that should receive the same treatment as bonds held by private sector investors. There is a fair and simple solution to the impasse:?? First, compensate Russia for the concession granted to Ukraine in the original bond purchase. Second, after compensation for the original concession, treat Russia the same as private sector investors in the debt restructuring.? The solution will have minimal impact on the sustainability of Ukraine’s debt. For Russia, the net effect is no write-down in nominal amount, an increase in the interest rate from 5% to 6.50% and an extension of maturity of 4-12 years from 2015 to 2019-2027.? The Most Favored Creditor clause under the Ukraine debt exchange will not be triggered. The solution is fair for Ukraine, fair for Russia and fair for the private sector investors. It recognizes the subsidy that Russia provided to Ukraine when Russia purchased the bonds in 2013 and it recognizes Ukraine's need for a debt restructuring. I.? Positions of Russia and Ukraine Russia considers the bonds that it purchased from Ukraine in December 2013 an official loan that was made on highly concessional terms.? The interest rate on the bonds is 5% compared to market yields of 12% on 2-year maturity Ukraine US$ bonds in December 2013. Therefore, the bonds should receive preferential treatment in any restructuring.Ukraine states that the bonds are a commercial investment identical to the bonds held by private sector investors and should therefore receive the same treatment in the debt restructuring. II.? Solution: Compensation for Original Concession then Equal TreatmentThere is a fair and simple solution to the stalemate based upon a two-step process: A.? Step 1: Compensate Russia for the Concession in the Original Bond PurchaseRussia should be placed on an equal basis with private sector investors at the time of the Russian bond purchase in 2013.? Russia will swap its existing bonds for new bonds.? The new bonds will reflect the market discount of a 5% coupon 2-year maturity Ukraine US$ bond held by private sector investors at the time Russia bought its bonds in December 2013. The December 2013 market value of a 5% bond due in 2 years was approximately 88% of nominal amount (12% yield). Russia will therefore exchange its US$ 3 billion of existing bonds for new bonds with a December 2015 maturity in a nominal amount of US$ 3.46 billion. ? Alternatively, Ukraine could issue to Russia US$ 0.46 billion of additional bonds that would equal the value of the December 2013 market discount. B.? Step 2:? Russia Treated like Private Sector Investors in the Exchange? Russia will tender the US$ 3.46 billion of new bonds into the debt exchange on the same terms as private sector investors.? There is minimal impact on the sustainability of Ukraine’s debt. The compensation of the concession in Russia’s original bond purchase will only raise Ukraine’s post-exchange debt by US$ 0.37 billion ((3.46 – 3.00) x 0.80 exchange ratio) or 0.5% of GDP. III.? Net Result for RussiaThe net result of the solution for Russia is: A.? 7.7% write-down in nominal amount. Russia will receive US$ 2.77 billion nominal amount of new bonds under the exchange (3.46 x 0.80 exchange ratio) or 92.3% of the original US$ 3 billion bond nominal amount; B.? Increase in interest rate from 5% to 7.75%.? The new bonds issued in the exchange carry a 7.75% coupon. The increase in the interest rate will fully compensate for the 7.7% nominal write-down in 3.5 years (7.7/((7.75 x 0.923 ) – 5))). From then on, Russia receives a profit from the higher interest; andC.? Extension of maturity of 4-12 years from 2015 to 2019-2027.? The result does not include any value for the GDP-linked Securities that Russia will receive in the exchange. IV. Solution with No Write-Down of Nominal Value Russia has objected to any write-down in the nominal amount of its bonds. Debts to official lenders are traditionally only written down in the case of very poor countries (HIPC Initiative). Even when private sector lenders take write-offs, official lenders maintain the nominal value of their claims and provide debt relief through maturity extensions (Greece, Argentina). Under the Ukraine exchange, Ukraine can offer bondholders that do not accept the exchange other bonds as long as their net present value is equal to the net present value of the bonds offered in the exchange. A 10% discount rate is specified for the valuation process. To eliminate any nominal write-down of the Russian bonds, Ukraine could exchange the post-compensation US$ 3.46 billion of bonds for US$ 3 billion of new bonds with maturities matching the 7.75% coupon bonds issued in the exchange but with a coupon of 6.50%. At the 10% valuation discount rate, the 7.75% coupon bonds with a 7.7% nominal write-down and the 6.50% coupon bonds with no write-down in the nominal amount have the same net present value. (See Appendix below). Under the no nominal write-down option, the net result of the solution for Russia is: A.? No write-down in nominal amount. Russia will receive US$ 3 billion nominal amount of new bonds matching the original US$ 3 billion bond nominal amount; B.? Increase in interest rate from 5% to 6.50%; andC.? Extension of maturity of 4-12 years from 2015 to 2019-2027.? V.? No Trigger of Most Favored Creditor Clause The Ukraine debt exchange contains a Most Favored Creditor clause.? This clause prohibits the government from offering better terms to bondholders who refuse the exchange (hold-outs) than those received by bondholders who accepted the exchange. The Most Favored Creditor clause will not be triggered by the solution because Russia will receive its compensation for the concession in the original bond purchase before the exchange is completed (Step 1 in Section II above). Russia will then receive the exact same treatment as the private sector bondholders under the exchange (Step 2 in Section II above). ? VI.? Private Sector Bondholders Should Accept the Solution Ukraine's private sector bondholders should accept the solution to the Russian bonds. Russia is simply placed on an equal basis with private sector investors at the time of the Russian bond purchase in December 2013. Russia then receives the same terms as the private sector bondholders under the debt exchange. The compensation of the concession in Russia’s original bond purchase will have little effect on the value of the proceeds received by investors. Ukraine would publish a short supplemental exchange offer memorandum outlining the resolution of the Russian bonds to comply with securities regulations. The solution eliminates the risks for bondholders who accept the exchange if a resolution is not achieved and Russia pursues legal action to enforce its rights. The history of Argentina’s debt exchange shows that hold-out bondholders can use the courts to disrupt payments to investors who accept debt restructurings. AppendixEquivalence of Nominal Write-Down and No Write-Down Structures (1) 7.7% Nominal Write-Down No Nominal Write-Down 7.75% Coupon 6.50% Coupon (as % of original nominal amount)InterestPrincipalTotalInterestPrincipalTotal 3/20163.577-3.5773.250-3.2509/20163.577-3.5773.250-3.2503/20173.577-3.5773.250-3.2509/20173.577-3.5773.250-3.2503/20183.577-3.5773.250-3.2509/20183.577-3.5773.250-3.2503/20193.577-3.5773.250-3.2509/20193.5774.6158.1923.2505.0008.2503/20203.398-3.3983.088-3.0889/20203.39810.96114.3593.08811.87514.9633/20212.973-2.9732.702-2.7029/20212.97310.96113.9342.70211.87514.5773/20222.548-2.5482.316-2.3169/20222.54810.96113.5092.31611.87514.1913/20232.124-2.1241.930-1.9309/20232.12410.96113.0851.93011.87513.8053/20241.699-1.6991.544-1.5449/20241.69910.96112.6601.54411.87513.4193/20251.274-1.2741.158-1.1589/20251.27410.96112.2351.15811.87513.0333/20260.849-0.8490.772-0.7729/20260.84910.96111.8100.77211.87512.6473/20270.425-0.4250.386-0.3869/20270.42510.96111.3860.38611.87512.261Total 92.30100.00Net Present Value at 10% Discount Rate (2)81.0681.06(1) Both structures include the compensation for the December 2013 market discount on Ukraine bonds at the time of the Russian purchase. (2) The net present value of the bonds received in the exchange without compensation for the December 2013 market discount is 70.26% of original nominal amount. ................
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