Bond Market Insight-Government bond auction results: when expect unfreeze of the primary market?

This past Tuesday\'s unsuccessful government bond auction was the third consecutive one in a series of failures, due to poor market conditions. In brief, only eight purchase orders were submitted at Tuesday\'s auction, with bids totaling a mere UAH145m. This showed a substantial reduction of demand by investors for local-currency government debt, as the previous auction brought nineteen bids for a total volume of UAH495m in new government debt. In essence, investors were largely expecting this very outcome to cause the MoF to cancel the auction because of such poor market conditions and lack of interest. Indeed, those bidders who submitted buy orders during the last three auctions were demanding higher yields: they raised their bids by 1.5-2.0ppts across the entire range of securities auctioned by the MoF (see chart below).

In light of the last three unsuccessful government bond auctions, the question naturally arises as to when the situation will change. In our view, the following factors should be taken into consideration:

Fiscal policy. As the current fiscal year-end approaches, accessible funds available to the private sector contracted recently on the back of tax payments, and subsequently these funds were accumulated by the government. Thus, the total amount of funds at banks\' corresponding accounts with the NBU, being the proxy of free accessible funds available to the private sector, declined to UAH16bn this week from the November average of UAH20bn. At the same time, government\'s treasury account saw a nearly two-fold increase of its balance over the last month, reaching UAH11bn as of December 1st from UAH6bn as of November 1st. In our view, the government will make its monthly expenses closer to the second half of the month and hence the funds will come back from the public sector accounts to private sector ones.

Monetary policy. As of yesterday commercial banks held UAH9bn of NBU\'s certificates of deposit. A majority of these assets (73% or UAH7bn) are coming due in the second half of December, beginning December 17.

IMF. We believe there is a 75% probability of obtaining the second tranche of the IMF loan at the end of December. This will allow the government to ease the strains over the upcoming redemptions and interest payments of over UAH6m in local-currency government bonds.

Investment conclusion. Ukraine\'s authorities, the government and MoF in particular, remain in quite comfortable territory in dealing with its prime lenders, particularly with the IMF, which is expected to disburse the US$1.5bn second tranche of the loan at the end of 2010, and with Russia\'s state-owned VTB, which yesterday extended its US$2bn loan for another 6-month period. With these supportive factors, the MoF is likely to withstand the tough market conditions of early December by cancelling the remaining scheduled auctions and begin auctions again after the prolonged year-end holidays conclude on January 11th. At that time, yields for local currency government debt are likely to remain higher compared to the low levels seen in early November. If that is the case, the MoF will have to accept the higher yields as acceleration of economic activity and hence lower financing needs will not materialize in 1Q11.