As Ukraine repays its $1 billion (R10.7bn) dollar bond, sentiment for the country’s notes is souring with the economy withering amid fighting between government forces and pro-Russia separatists.

The yield on the July 2017 note fell seven basis points to 9.62 percent at 11.28am on Wednesday in Kiev, paring the increase to 10 basis points in the past week amid a government crackdown on rebels in Donetsk and Luhansk in Ukraine’s industrial heartland in the east.

Optimism that the country would avoid war with Russia spurred an 8.7 percent return in its dollar-based securities last month, the most among 56 emerging markets tracked by Bloomberg.

While an International Monetary Fund (IMF) bailout is helping the country repay the dollar note which matured on Wednesday, the European Bank for Reconstruction and Development forecasts the economy will shrink 7 percent this year after the government pledged to lower its budget deficit to win the aid. Russia, which annexed Ukraine’s Crimea peninsula in March, has given the country until Monday to prepay for natural-gas supplies or face a cutoff.

“I am very sceptical about Ukraine in the medium term as growth prospects are dim and popular support for the very tough IMF-imposed measures may evaporate soon,” Ivan Tchakarov, an economist at Citigroup, said from Moscow on Monday. “While default risks have been averted, I can see no reason to remain bullish on Ukrainian bonds.”

Goldman Sachs Group is maintaining a “relatively cautious” longer-run view on Ukraine because of the difficulty of implementing “deep structural economic and institutional reforms”, while also integrating and reviving the economy of conflict-hit eastern regions, Andrew Matheny, a Moscow-based analyst at the bank, wrote in a report dated Tuesday.

The IMF on May 1 approved $17bn of loans to keep the country afloat for the next two years and help revive growth. The funds won’t be enough if the government loses control of eastern lands, as the predominantly Russian-speaking Donetsk, Luhansk and Kharkiv regions account for 30 percent of the country’s industrial output, the Washington-based lender said.

Government troops had killed “a large number of terrorists” on Tuesday as fighting continued, parliament Speaker Oleksandr Turchynov told lawmakers in Kiev. President-elect Petro Poroshenko has vowed to wipe out the insurgents and re-establish order after winning the vote in a May 25 election.

“Fighting seems to have intensified,” Timothy Ash, head of emerging-markets research at Standard Bank in London, said on Tuesday. “The market seems oblivious to the risks, but the longer this conflict on the ground drags on, with yet more casualties, the closer we get to a former Yugoslav point of no return.”

Moody’s Investors Service downgraded Ukrainian bonds three times in the past nine months, with the last cut in April taking the credit rating to Caa3, nine steps below investment grade and on par with Greece. The country has $20.8bn of principal and interest payments coming due this year and next, including the note which matured on Wednesday, data compiled by Bloomberg shows.

Ukraine’s government ordered the repayment of the notes due and is preparing to repay $1.6bn of notes from state utility Nak Naftogaz Ukrainy maturing in September, according to Halyna Pakhachuk, head of the finance ministry’s debt department in Kiev. The country sought to offer international bonds when violence in the east subsided.

“I strongly hope that the civil conflict in Ukraine will be stabilised and markets will allow us to borrow internationally on reasonable terms,” Pakhachuk said. “But at this moment, Ukraine’s credit ratings are like a millstone around our neck.”

Société Générale raised Ukrainian sovereign debt to overweight on May 28 from a previous neutral stance, according to a research note from Regis Chatellier, a director of emerging-markets credit strategy.

“Ukrainian euro bonds may not rally further but the yield remains attractive given the substantially reduced geopolitical risks,” Chatellier said on Tuesday.

Russian President Vladimir Putin, who faces sanctions from the US and Europe, had withdrawn most of his forces massed on Ukraine’s border, US Defence Department said on May 30.

“Investors may finally understand that Putin is likely not sending troops to Ukraine, so all that fat risk premium has disappeared,” Tchakarov said. – Bloomberg