Convergence has been the mantra of fixed-income investors in Europe for the better part of a decade. They made bundles in the 1990s by buying government bonds in Italy, Portugal and Spain and watching their once-high yields fall toward the low levels prevailing in Germany before the launch of the euro.
Then the convergence game moved east in anticipation of the expansion of the European Union. Yields on Eurobonds issued by the Czech Republic, Hungary, Poland and other prospective EU members have declined sharply over the past four years, spelling big profits for investors who bet that yields would approach the levels found in Western Europe.
Now a third big convergence play is under way. Investors increasingly are moving into the EU aspirants’ fast-growing domestic bond markets. In doing so, they are trading the relative safety of euro- and dollar-denominated bonds for the higher yields and possible currency gains from issues denominated in Czech koruny, Hungarian forints, Polish zl,oty and -- to a lesser extent -- Slovakian koruny. Fund managers anticipate that with these countries on a course toward eventual European Monetary Union membership, their currencies will become much safer bets than those of other emerging markets. For Eastern European governments, meanwhile, the development of liquid domestic bond markets is a key policy objective; achieving it will enable them to finance their growing budget deficits, reduce currency risk and provide a secure home for their nascent pension funds.
“You’re seeing crossover funds coming in and looking at these markets for the first time,” says Steve Ellis, emerging-markets strategist at Lehman Brothers, which has dubbed the countries “waiting room markets” as they prepare for EU membership next year. (Crossover funds try to achieve a small pickup over broad bond benchmarks by occasionally venturing away from their normal indexes for additional yield.) With the rates in most developed countries lower than they have been in decades, “we’re seeing clients who wouldn’t traditionally have looked at these emerging markets move over looking for yields,” Ellis says.
The domestic paper not only offers better yields than Western European bonds and the promise of currency appreciation during the run-up to acceptance; it’s also an important diversification play for emerging-markets investors. “These countries are no longer in the class of ‘emerging market,’” declares Marc Kersten, a fund manager and Eastern European expert at Deutsche Bank’s mutual fund arm, DWS Investments. “That means the correlation between this new asset class and other classes is very low, and then you have advantages because of the diversification effect.”
These investment plays have been a boon to foreign fund firms like DWS, which has two dedicated convergence funds with assets totaling E500 million ($541 million) -- all of it in local currency bonds, mostly from the Czech Republic, Hungary, Poland and Slovakia. DWS holds a further E400 million to E500 million in Eastern European bonds in a number of crossover funds. “We buy these markets opportunistically if we think that they will rally and outperform the markets that are in the benchmark of these funds,” Kersten explains.
Adds Barbara Farbiszewska, a fund manager at Germany’s Union Investment Privatfonds, which has about E3 billion invested in Eastern European bonds through two dozen funds, “We see these countries going in the right direction: improving fundamentals, boosting productivity and having high growth -- catching up.”
An early interest in the region’s debt has paid off handsomely. From January 1, 2000, through the start of 2003, the Polish bond market returned 65 percent in local currency (71 percent in euro terms), the Czech Republic’s 34 percent (53 percent in euros) and Hungary’s 38 percent (48 percent in euros). These numbers compare with a 23 percent return over the same time period for German bonds issued in euros. The two-year local return in Slovakia (three-year figures are not available) through January 2003 was 27 percent, easily topping the German bonds’ 15 percent gain in that time.
Of the ten countries that the EU is preparing to admit in 2004, investors regard Poland, Hungary and the Czech Republic as having the greatest potential in terms of returns and the liquidity of their markets, with Slovakia a promising but distant fourth. The other six EU-eligible countries -- Cyprus, Estonia, Latvia, Lithuania, Malta and Slovenia -- are considered too lacking in liquidity to be viable investment destinations.
As a result of the initial interest, spreads between the developed and developing markets’ Eurobond yields have narrowed fast. For example, a ten-year Polish government Eurobond today trades at about 60 basis points over a comparable German bond. Three years ago the spread was as much as twice that size.
The tighter euro-based spreads have spurred subsequent investor interest in the local markets. The domestic Hungarian bond market grew from the equivalent of E11 billion in December 1999 to E18 billion last September, Poland’s from E16.8 billion to E39 billion, the Czech Republic’s from E6.3 billion to E13.4 billion and Slovakia’s from roughly E2 billion to E4.5 billion. In all, these markets now have a capitalization of about E75 billion.
To be sure, plenty of risk remains. The Czech Republic, Hungary, Poland and Slovakia still have far to go to bring their deficits down to 3 percent of GDP and to meet other economic targets in line with EU standards. What’s more, a war, disruptive terrorist incident or major debt default by a less ascendant emerging-market country could rock them pretty hard. Once the waiting-room nations get their economic houses in order, the clock on convergence will be ticking. Foreign investors will start to look elsewhere for better spreads and currency gains -- some have already begun to make small moves into countries like Turkey and Croatia, which they see as the next generation of convergence plays.
Indeed, some investors and analysts now urge caution in approaching the local markets. “Our feeling is that the market has overdone the convergence theme,” says Mohamed El-Erian, head of the emerging-markets management team at Newport Beach, Californiabased Pimco, the bond management arm of German insurance giant Allianz.
The spreads versus other markets, although still much more generous, have tightened substantially. Five-year Polish zl,oty bonds, for instance, dropped from 1,100 basis points over comparable German bonds in late 2000 to 232 basis points in January. Hungarian spreads narrowed from 950 in early 1999 to 334, Czech Republic spreads from 500 to virtual parity during the same period and Slovakian spreads from 310 to 164 within the past year.
Governments in Eastern Europe, notes El-Erian, still need to significantly tighten fiscal policy for convergence to proceed as smoothly as the market’s pricing projects. He expects a fair amount of rate volatility as these countries progress toward EU acceptance. If these nations don’t follow a straight track to EU accession, their financing costs can be expected to skyrocket, since investors will expect to be compensated for the risk.
“That’s the history of these trades,” El-Erian says. “The destination can be held constant, but the voyage is very bumpy.”
Among the four main candidates for EU acceptance, Poland and Hungary are big draws for investor money; Union Investment’s Farbiszewska and DWS’s Kersten, for example, keep the vast majority of their holdings in these two markets.
“We tend to overweight Hungary and Poland because you get much more yield and because of the promise that you might have some more currency appreciation,” says Kersten. “We don’t see that for the short term in the Czech market.”
Hungary, adds Farbiszewska, has an open economy that has become a major exporter of auto and machine parts as well as electronics to euro-zone countries. Its inexpensive skilled labor force is helping to attract foreign direct investment -- nearly E2.8 billion in the past two years. What’s more, the country’s short-term rates -- about 6.5 percent -- tower above the euro zone’s 2.75 percent level, and its so-called five-by-five-year forward spread -- based on the projected rate for five-year bonds in five years’ time -- is still a sizable 65 to 70 basis points.
Inflation is Farbiszewska’s main concern with Hungary. Although it dropped from double-digit levels in 2000 to 4.8 percent last year, inflation is expected to be at least 4 percent this year and next. Getting the rate down closer to euro-zone levels -- about 2 percent -- should be the main government priority, she says, but growth seems to take precedence. The left-leaning coalition under Prime Minister Péter Medgyessy has allowed the forint to depreciate to help spur exports, and the central bank cut short-term interest rates by 200 basis points last month.
“What they are doing with the Hungarian forint and interest rates is not what they should be doing if they see inflation as a target,” Farbiszewska says.
Although still reliant on slow-growing industries like steel and coal, Poland’s economic fundamentals are currently better than Hungary’s. Through tight monetary policy the Polish central bank pared the inflation rate from 8.5 percent in 2000 to 1.1 percent last year, and it’s expected to stay below 3 percent for the next two years. “There is no danger from the inflation side at the moment,” says Farbiszewska.
Real GDP growth, however, has tailed off to about 1 percent in the past two years, from 4 percent previously, but Credit Suisse First Boston forecasts growth of 3 percent in 2003 and 4 percent next year. Poland, notes Koon Chow, European local currency strategist for CSFB, “is in a situation that if there’s a pickup in growth, it could enjoy a sharp compression of the deficit to euro-zone levels.”
One major concern for investors in Poland: Last year Prime Minister Leszek Miller brought in a new Finance minister, Grzegorz Kol,odko, whose brief is to boost growth by jump-starting exports. Kol,odko has become the leading exponent of a weaker zl,oty and has been fighting the central bank’s refusal to intervene to keep the zl,oty artificially low.
The Czech Republic -- despite sizable auto and electronics industries -- has been of much less interest to foreign investors (outsiders hold less than 8 percent of the country’s bonds, compared with more than 40 percent in Hungary). That’s in part because its short-term rates are so low. Already on par with the euro zone’s 2.75 percent, they offer little yield attraction.
“German government bonds have a risk premium over the Czech market, which is of course ridiculous, because it is much lower rated,” says DWS’s Kersten.
Also worrisome: The centrist coalition government of Prime Minister Vladimír Spidla openly says it won’t get deficits down to EU-mandated levels until close to the end of the decade. “At least you can say they are honest about it,” Farbiszewska points out.
The lack of foreign interest in the Czech bond market can be a blessing, says Farbiszewska. One consequence is that the local market tends to be much less volatile than its bigger Eastern European counterparts, which are subject to occasional bouts of foreign selling. Foreign direct investment has poured into the country -- E7.5 billion in 2002 -- helping it build a strong export base from a growing auto industry, which produces local Skoda and German Audi cars.
Slovakia has been the laggard in the group, liberalizing its economy and privatizing its major companies at a much slower pace. And its bond market is less than half the size of the Czech Republic’s. “Slovakia is fairly small, and trading is quite tight,” says Dresdner Kleinwort Wasserstein European strategist Stephan Monissen. He views both sides of the former Czechoslovakia as currency bets now.
Slovakia does offer one advantage to bond investors: Its rates are much higher than those of the Czech Republic. The spread to comparable short-term euro rates is nearly 375 basis points. CSFB sees inflation leaping from 3 percent in 2002 to nearly 9 percent this year, mostly because of liberalization of utility rates. However, analysts and investors expect the rise to be a one-time occurrence and project that inflation will settle close to its previous level in 2004. Farbiszewska says that Slovakia’s low labor costs and growing ties to French and German carmakers should help it grow as an exporter to Western Europe, and that, she notes, is helping it attract foreign direct investment -- E3.5 billion last year. And she appreciates another feature: “Slovakia has the cheapest currency” of the four top EU aspirants.
Sticking mostly to government offerings, neither DWS nor Union has delved heavily into local corporate bonds in any of these countries, because, as Kersten says, “Usually, if you don’t know a company, you don’t want it.” Still, both firms have bought the debt of major international companies offered in the local currencies. Among the purchases: German mortgage lender Depfa Bank’s Slovakian koruna deal; General Motors Corp.'s Hungarian forint bonds; Volkswagen’s, DaimlerChrysler’s and the Netherlands’ SNS Bank’s offerings in Czech koruny; and German bank HVB Group’s Polish zl,oty bonds. Supranational agencies like the European Investment Bank have also issued Polish zl,oty bonds.
Adding depth to the market and providing comfort to foreign investors is the growing participation of local pension funds. Both Hungary and Poland are seeing the growth of domestic demand for local currency bonds because pension legislation has mandated employee contributions to private schemes and channels investment toward local bonds. “They are moving to a fully funded private pension system, and that is being supplemented by money that is being taken out of people’s wages by the government before they get it and transferred directly to the private fund,” explains CSFB’s Chow.
At year-end 2002 the value of pension fund assets reached E6.2 billion in Poland, E2.6 billion in Hungary and E1.7 billion in the Czech Republic, according to a recent Goldman, Sachs & Co. study. By 2006, says Goldman, Polish pension assets should nearly triple to E17.4 billion; in Hungary they’ll grow to E6.8 billion over the same period, and in the Czech Republic they’ll rise to E4 billion.
Cultivating a strong local investor base before entering the EMU is vital, because once these countries share a common currency, they will lose much of their current attraction to foreign investors. Says László Búzás, managing director of Hungary’s debt management agency, “Having local investors who might be loyal to the Republic of Hungary within the boundaries of an integrated European market is a very important goal.” Adds Farbiszewska, “It’s not the best situation when you have only speculators and hot money and foreign investors from outside.”
The local money is important to foreign buyers as well. Chow says a strong domestic capital pool provides an important hedge: “You take the view, I can sell these bonds regardless of what the currency is going to be because I’ve got local investors who bring in money.”
As encouraging as the development of these markets is, they are hardly foolproof investments. “There’s always a risk that we’ll have some kind of emerging-market crisis,” admits Kersten, explaining that while there is much less of a correlation between emerging markets and the convergence economies of Eastern Europe, if there’s “a general spike in worldwide risk aversion -- a war in Iraq, for example, or Brazil is not able to pay its debt or something like that -- then these markets may also suffer.”
The route to ultimate EMU membership also requires currency-conscious investors to watch each country’s situation carefully. Farbiszewska notes that to get better import-export conditions, the governments will want their currencies pegged to the euro at the lowest rate possible. “They want a weaker currency at the point in which they join the EMU, so at some point they will develop the strategy to do this,” she says. “This is a question mark for the future.”
There are also questions as to how fast the track to EMU really is. CSFB’s Chow maintains that the former Eastern bloc convergence economies always viewed alignment to Western Europe through EU membership as the big prize. “As for membership to the EMU,” he says, “they’re not wholly convinced of the benefits from it. They would like to have lower interest rates, which they know will happen on entry to the EMU, but they’re not sure if they’re willing to stomach the cost vis-à-vis cutting fiscal spending. So they’re not superaggressive about entering the EMU soon afterwards.”
Even if they did want to push for EMU membership, these countries would be hard-pressed to get their budget deficits down to the 3 percent of GDP that the EU demands. “Bringing down the fiscal deficit is not so easy in these countries, so this is a huge challenge for them,” says Farbiszewska. CSFB estimates that Hungary’s deficit topped 9 percent in 2002 and that Poland’s broke 5 percent. The firm forecasts deficits of 5.9 percent and 4.8 percent in Hungary and Poland, respectively, in the year ahead. The Czech Republic, meanwhile, had an estimated deficit of more than 6 percent in 2002, and it’s not forecast to fare much better over the next two years. Slovakia’s deficit should be about 7.8 percent once 2002 figures are released, although CSFB forecasts it will fall closer to 5 percent this year.
Whether any of these countries have the political will to close these gaps in trying economic times is an open question. After all, even Germany can’t seem to meet these criteria these days. The Czech government doesn’t expect to join the EMU until between 2009 and 2011; Slovakia is aiming for 2008, but Hungary and Poland continue to maintain that they will be ready by 2006.
Even while focusing on the biggest of the current crop of EU aspirants, investors are looking beyond the 2004 group for the next generation of convergence plays. With spreads narrowing in these local markets, “somehow slowly but surely you have to find another candidate to trade in the future,” says Farbiszewska. “At the moment, we are starting to look at Turkey locally because we feel that in the future this could be a very important market for us.” She notes that Turkish lira-denominated bonds make up about 2 percent of Union Investment’s EU-related funds. Turkey -- where one-year notes bear a yield above 50 percent and the inflation rate exceeds 30 percent -- is slated at the end of 2004 to start discussing the parameters for joining the EU. Croatia -- which isn’t even on the EU agenda at the moment -- has issued Eurobonds and could someday become a convergence play, Farbiszewska says.
Either of those events is a long time away, but convergence plays are a self-limiting class. The question for investors like Union and DWS is always, Who’s next in the waiting room?
