UNTIL JUNE, IT had been a great 18 months for central and eastern European Eurobonds. The global backdrop of falling interest rates drove unprecedented amounts of money into emerging-market debt, as developed-market investors hunted abroad for yield. Many of these investors, including significant ones from Asia, were first-time buyers of CEE debt and thus most interested in straightforward Eurobonds, rather than more complicated local currency plays.
This, combined with a general optimistic assessment of the speed of CEE convergence towards EU accession and the single currency, helped to drive down CEE sovereign and blue-chip corporate bond yields. For example, for Hungary and Poland yields are now about 50 to 60 basis points over German Bunds. EU accession countries' Eurobond yields have all but converged with EU levels. Early buyers of these countries' bonds have enjoyed substantial capital gains.
Fundamentals ignored
It may well turn out that this was a bubble, driven not by a discerning analysis of the convergence process or individual countries' economic fundamentals but by a desire for yield and an over-optimistic view of the speed of convergence at a time when some countries' economic fundamentals were deteriorating and political risk was increasing. Investors chose to ignore this. As one head of syndicate put it in January: "The fiscal situation of the accession countries is not a big concern for most investors. Look at Hungary - it trades very tight and is a complete basket case."
As new money carried on flowing into CEE Eurobonds, more savvy emerging-market investors placed their bets elsewhere, in Latin America or Asia. Pimco, for example, moved out of CEE bonds at the start of the year. Mohamed El-Erian, the investment house's head of emerging market debt, explained: "The internal policy dynamics of some of these countries suggest a considerably more challenging convergence process than appears priced in current spreads."
Now the bubble looks ready to burst. Encouraging signs of recovery in the US economy have led to a global widening of fixed-income yields, as money flows out of bonds and back into equities. That has hit CEE Eurobonds. Marc Kersten, head of CEE debt at DWS Investment, says: "CEE hard currency [euro or dollar-denominated] bonds have suffered in line with the general sell-off in core government bond markets, which is around a 4.5% drop in return of 10-year government paper since the middle of June."
This has been exacerbated by recent economic news from CEE countries which, Kersten says, "has been more on the negative side, such as budget deficit growth or a shift in EMU entry expectations". Both Hungary and Poland now look unlikely to join EMU before 2009, rather than in 2007 as they had hoped.
These factors mean investors seeking attractive yields and returns in the region in the next year might have to look farther afield than the dollar and euro-denominated sovereign bonds of Poland, Hungary and the Czech Republic.
Euromoney examines three investment strategies that look beyond the CEE Eurobond market: CEE local-currency debt, and equity investment in the Baltic states and in southeastern Europe.
There are two main ways to invest in the CEE debt market - through the Eurobond market or through the local-currency debt market. For the first six months of the year, and arguably for some time before that, the Eurobond market produced better returns. But as Marc Kersten of DWS Investment says: "In the second half of the year, local-currency bonds could outperform hard-currency debt."
Most analysts believe that the main CEE currencies - the Polish zloty, the Hungarian forint and the Czech koruna - will all appreciate in the next six months. In the first six months they underperformed, mainly because of the weak global economy, low foreign direct investment, and local political factors that hurt the currency markets. In Poland, for example, the zloty was undermined when finance minister Grzegorz Kolodko talked it down to try to boost the country's trade competitiveness. This, along with low FDI, domestic political scandals and poor economic data, pushed the zloty down 28% against the euro since the beginning of 2002.
In Hungary, the central bank intervened in January and June to weaken the forint to keep it within its trading band. This led to a lot of forex volatility and scared off many investors from the local-currency market.
However, the local-currency play now looks more attractive. In Poland, Kolodko has resigned, to the delight of hedge funds and other local-currency investors. The signs of growth in the German economy, where the stock market has risen fast this year, will help Poland's own recovery. FDI in particular is likely to pick up. CSFB's economists expect it to grow from $4.3 billion in 2003 to $5.4 billion in 2004. Because of this they say: "The Polish zloty is the most undervalued currency after the Argentine peso on our real effective exchange rate measure. [It is] 10% undervalued versus its 36-month average. CSFB economists predict the zloty to strengthen by 7% from current levels, to Zl3.63 to the dollar, within the next 12 months."
The Czech and Slovak currencies have both been hit by political risk in recent weeks, as the coalitions in each country have looked vulnerable. In the Czech Republic, the coalition, which has a majority of one, has threatened to fall apart over public sector finance reform. In Slovakia, the conservative/liberal coalition may self-destruct over a proposed abortion law.
Most analysts expect the Slovak government to hold together, but RZB's Czech analyst, Ivo Nedjl, only gives the Czech government a 50-50 chance of surviving intact through the autumn. The coalition disputes are likely to entail volatility for both currencies over the next few months. The Czech koruna, for example, could weaken to 33 against the euro in the next few months, from its present 32.1. However, most analysts believe the medium-term outlook for both currencies is appreciation, thanks to the global economic recovery, domestic pick-up and increased FDI.
RZB expects the Czech koruna to go to 31 against the euro by June 2004.