Coming soon: the Eurorouble?

Dollar-denominated issues have been flooding out of eastern Europe recently, particularly from Russia and Hungary. But until now, European emerging market currencies have played only a small part in the Eurobond market, with the Czech koruna the only one used extensively. The main impediment to new currency sectors for Eurobonds has been the intricate convertibility restrictions placed on most central and east European currencies. Only the Czech koruna is 100% exchangeable with no strings attached. Even the Hungarian forint is still not fully convertible in spite of Hungary’s rapid economic reforms and near-western level of financial regulation.

But this may soon change, with investors and issuers showing a growing appetite for even non-convertible currencies. The first step to placing non-convertible local-currency debt so far has been through structured products, particularly on Russian treasury bills, giving dollar-bond investors full exposure to a local-currency debt instrument issued in the domestic market. And foreign investment in local-currency debt has been positive for the issuers, usually sovereigns or municipalities, since the flood of foreign capital has caused yields on almost all treasury bills and municipal debt to fall sharply over the past year throughout eastern Europe and the CIS. On a second level, a number of Polish zloty bonds have been issued, particularly by the World Bank. Restrictions on zloty convertibility have been side-stepped by settling payments on zloty bonds in dollars, Deutschmarks or, in one recent issue, Italian lire.

“We access these markets on a swap-driven basis,” says Gumersindo Oliveros, director of treasury operations at the World Bank. “The local-currency proceeds are swapped into the currency we need for onlending to our clients [generally dollars, Deutschmarks or yen]. We enter these markets because they provide cost-effective funding at the time but take a medium-term view. For example, we look for ways to help develop the market by bringing new products, extending the yield curve and the investor base for the currency, transferring know-how to local banks, and so on.”

Until devaluation of the Czech koruna earlier in the year, the Eurokoruna market was booming. This was not so much because borrowers had koruna funding needs but because they wanted to take advantage of opportunities to swap into dollars and come off ahead. The koruna-dollar and koruna-Deutschmark swaps markets are among the most active derivatives markets in the region.

Eurokoruna attractions

All Eurokoruna bonds have so far been issued by multilaterals, such as the World Bank and the EBRD, or by highly creditworthy borrowers, such as the Republic of Austria and a number of blue-chip European banks. Private Czech corporations have koruna funding needs but so far they have only issued koruna debt instruments domestically. “In terms of east European currencies, the Eurokoruna debt market is by far the most developed,” says Andrew Dell, assistant director of emerging market syndication and MTNs head at ING Barings. “The principal reason for this is that the Czech authorities made the decision to allow the currency to be convertible and Euro-clearable.”

The biggest Eurokoruna offering of the year was issued well before the currency devaluation. In January, Kr5 billion of fixed-rate two-year bonds were offered by Bayerische Vereinsbank Overseas Finance, offshoot of an AA German bank. Equivalent to $181 million at the time, the bond traded at an opening yield of 10.1%. Later in the year, investors in the Eurokoruna market lost out badly as a result of the June devaluation. As a result, Eurokoruna issues temporarily dried up.

But by September, the Austrian Federal Financing Department felt conditions were stable enough to issue another koruna instrument. Merrill Lynch lead-managed a $45 million Austrian sovereign Eurokoruna bond which proved that the Eurokoruna debt market was by no means out for the count. The issue was initially priced at a yield of 11.7% but the yield soon rose 60 basis points. The price has since recovered. However, the issue’s volatility was not related to any uncertainties about the koruna debt market but rather to a pair of issues from the European Investment Bank and German development bank Kreditanstalt für Wiederaufbau. These two issues shortly preceded the Austrian sovereign thus temporarily crowding the market.

“The currency devaluation has had a substantial impact on the number of Eurokoruna issues coming to market,” confirms one London-based market player. “At the beginning of the year, there was a period when a few issues were coming out every week. Now, I don’t think there are more than a few new issues each month.” Most analysts agree that the Eurokoruna market will remain of great interest to bond investors. This interest is in stark contrast to the koruna-denominated Czech equity market, which is still recovering from a series of trading scandals and the lack of a credible financial regulatory infrastructure. “The koruna-denominated debt issuers, like the World Bank, have no connection with any share registration or reporting scandals in the Czech republic,” points out one analyst. “At the same time, a buyer can get the high yield on exposure to the koruna. Thus, with a Eurokoruna bond, you get an extremely attractive issuer, nearly zero credit risk and a good return, but without facing the problems that may have been associated with investing directly in the Czech capital markets.”

For a sophisticated blue-chip borrower, accessing the Eurokoruna market, like issuing debt in South African rands, offers an opportunity to raise dollar-debt finance for as little as 40bp below Libor. Success depends on monitoring several markets at once, particularly dollar-koruna swaps, and issue precisely when the koruna proceeds from the bond can be swapped into dollars. The end result can be a rock-bottom dollar-financing cost.

“There are only a limited number of borrowers who could successfully access this market: the large multilaterals, and a number of triple A rated banks and corporates,” says Ernst Rosi, head of capital markets at Austrian bank RZB, which lead-managed a Slovak koruna World Bank Eurobond. “On top of that, there is only a limited number of buyers willing to take up Slovak koruna, Czech koruna or zloty debt. The issuers accessing this market can end up with a very cheap cost of dollar borrowing, but they are very opportunistic, sophisticated borrowers. They have to look at local interest rates, the local-currency swap rate and the market for eventually placing the bonds in order to successfully complete a cost-effective transaction.” Maturity drought

One notable drawback of tapping the Eurokoruna market is that it is difficult to issue long-dated paper. Dell explains: “At the moment, there is an inverted interest curve for Eurokoruna bonds. Investors won’t want to buy a 10-year bond when they can get a better rate on a one-year bond. I would expect the curve shape to change and that there will be more longer-maturity new issues.”

The Polish zloty, still not fully convertible, has been used to denominate seven Eurobond issues so far this year. The largest zloty issue of the year was a $55 million dollar three-year bond offered by Dutch bank Metro Finance at an opening yield of 18%. An official release from Goldman Sachs, bookrunner for the deal, comments: “Metro came to us looking for zloty funds and we managed to put together a deal which was designed to capitalize on the borrower’s name-recognition in German-speaking parts of Europe.” German retail investors have bought a number of zloty issues, primarily for the headline coupon rates – which are always nearly 20%  the strength of the name of the issuer and the fact that for some issues coupon payments are made in Deutschmarks. “The sales have been mainly to retail banks in Austria, Germany and Switzerland who were looking to place the bonds with private clients familiar with the Metro name and the credit story surrounding Poland,” the Goldman press release adds.

The lack of a currency-swap market for zlotys is holding back the Eurozloty market. But, with Poland’s optimistic credit story, it is likely to become increasingly popular with Europe’s yield-hungry retail investors.

Activity in the syndicated loan market may eventually pave the way for creditworthy central and eastern European corporates to access the Eurobond market directly in their own currencies. The market for syndicated loans provides a means to avoid the tangle of thorny regulatory problems facing international bond issuers. Local governments impose heavy regulations on borrowing by issuing negotiable debt securities on international markets. For example, a Russian corporate or municipal seeking to issue bonds must wait at least six months to clear the transaction through the notoriously bureaucratic finance ministry and Russian central bank. By contrast, only a limited degree of regulation is imposed on private-bank borrowing.

On the buy side, syndicated loans come under virtually no scrutiny from western regulatory authorities, such as the SEC in the US. The lack of regulatory obstacles makes thismarket an ideal first port of call for many east European municipal or corporate borrowers looking to tap into foreign funds.

In Hungarian forint, for example, ING Barings lead-managed a five-year Ft25 million ($134 million) syndicated loan last summer to Pannon GSM Telecommunications. Including a dollar-bond issue, the total borrowing package was worth $225 million, which was to be used to refinance existing debt. The effective dollar cost of borrowing for Pannon, 100bp over Libor, made this as good a deal as any Eurobond issue  something which, for forints, is not possible under existing currency regulations. The 11 banks in the syndicate included Dai-Ichi Kangyo Bank, Raiffeisen Unicbank, Merita Bank, CIBC Wood Gundy, Creditanstalt, Sumitomo Bank, Kredietbank and the Hungarian Foreign Trade Bank.

Perhaps the most interesting development in emerging market-denominated debt has come through the rapid development of derivatives. The Russian GKO market, which with capitalization of over $60 billion is the largest of any debt market in eastern Europe or the CIS, was once wrapped in foreign-ownership restrictions and currency-convertibility regulations. But now GKO structured notes offer foreigners effective rouble-denominated debt exposure. According to one local trader: “In order to play the GKO market directly, a foreigner has to be very sophisticated and active. The structured products available to directly access GKOs have played a huge role in bringing in western capital.”

Before the structured notes boom, GKOs were accessible only to well-connected insiders. An array of restrictions, depending on whether investors were domestic or foreign, had kept capital inflows low and yields high. Since just before last year’s presidential elections, when yields peaked at 236%, GKOs have become one of the most popular debt instruments in the region as a result of the proliferation of GKO-linked derivatives. The first, offered by ING Barings from its Moscow desk, paid the holder a flat dollar return indexed to the rouble cash market. As long as the underlying GKO paid out, the holder’s dollar return was virtually guaranteed. What’s more, the investor could ignore concerns about the rouble corridor (the currency’s permitted band of fluctuation), conversion risk, ambiguous and unstable regulations on foreign ownership and, most of all, an electronic custodial and settlement system in which many funds managers had little confidence.

Recently, the hottest up-and-coming local currency-denominated debt instruments have been Romanian and Ukrainian treasury bills. So far, as in the early days of the GKO market, these have been reserved for insiders with a local trading base and the ability to cope with onerous repatriation laws and foreign-ownership restrictions. It is expected, though, that some London trading desks will soon offer structured products opening these untapped debt markets to a fresh wave of foreign capital.

Emerging market debt issues are bound to increase in number as the EU’s single currency looms nearer. “With the introduction of the euro, there will no longer be any chance to get a yield pick-up by going into higher yielding EU currencies, says Dell at ING Barings. “To get a yield pick-up, the focus will be on taking a greater credit risk or going to a non Emu/euro issue and taking a currency risk. If investors believe the Czech Republic will eventually join the EU and hence Emu, they will potentially do extremely well with a convergence play, given present rate differentials of 6% to 8%. This may lead to a bigger Eurokoruna market.”

No official timetable has been set for the zloty and forint to become convertible and Euro-clearable, but they are still regarded as strong candidates for Eurobond issuance in the near future. “Poland and Hungary are both rapidly developing economically, and would be currencies likely to attract demand for Euromarket debt issues,” Dell says. “If you step back and look at the market, you see that the Eurokoruna is part of the development of an entirely new and very significant asset class of local currency debt.”