Following Emu, bond traders are scouring non-euro EU countries for the next convergence play hot-spots. Now that the main convergence-play currencies of recent times – Italy, Spain, Ireland and Portugal – are in the euro club, those non-euro countries that might join the euro over the next few years are attracting attention. Greece has emerged ahead of the UK, Sweden and Denmark as the most popular source of convergence plays.
Phyllis Reed, government bond economist at Barclays Capital, says: “The Greeks are the best value as their spreads are high – just over 250 basis points – in relative and absolute terms, and they are most likely to join the euro next. The Greek government has a programme in place to qualify for Emu by 2001 and it looks as if they will achieve this. Given the UK electoral cycle, Emu will probably not happen until 2002. The same can be said for Scandinavia. Spreads in Scandinavia look too low to cause much excitement in convergence plays, and though the UK still offers opportunities you might be better off with swaps.”
But traders are not ignoring Denmark and Sweden entirely. Some are playing in those markets through euro-financed trades. It’s a similar bet to the one traders took on Italy in 1997 as it became reasonably certain that Italy would be joining Emu. While Deutschmark/lira exchange rates remained stable, Italian interest rates were higher than Deutschmark rates, particularly in shorter maturities, so bond traders borrowed Deutschmarks to finance buying Italian two-year paper. Traders are now borrowing euros at low rates, converting to krona/krone and going long bonds maturing before the end of 2001. Investors are taking the risk that the Scandinavian currencies will fall against the euro.
Greece remains a much more exciting convergence play than Scandinavia. Although it is a much riskier credit than other EU countries, spreads on Greek bonds have already come down a long way against German Bunds. Though Greece has much to do if it is to join by the earliest possible date in 2001, the government has just held its largest auction in which a record Dr440 billion ($1.6 billion) of bonds were sold. The auction was oversubscribed more than six times.
The main foreign holders of Greek bonds tended to be UK and US investors. Other investors are expected to return there as skittishness in emerging markets stabilizes. Some hedge funds were reported to be making convergence plays at the beginning of the year. Assuming that Greece would get into Emu made currency risk much more acceptable for them. Their positive-carry trades used Deutschmark borrowings to finance positions in short-dated Greek bonds. This trade has pushed the drachma up to the point where it has recovered half the value it lost after its 12% devaluation against the ECU in March 1998.
Troy Bowler, fixed-income analyst at Deutsche Bank, says: “For many leveraged accounts, there is less convergence to go for than is available to the real money accounts due to the high cost of funding positions in Greek bonds. For example, if a fund borrows money at 10% and buys the 2014-maturity bond, that bond’s yield has to fall by around 40bp over a year just to break even. That said, many of the leveraged accounts who wanted to hold Greece have already done so and have made a great deal of money from it. The point about convergence trades is that they are politically driven. In the long term, economic factors are important, but over the medium term these kinds of trades depend very much on whether or not the country is in line for EMU or EU membership. Look at 1995, when the idea of convergence trades was starting to become obvious. Most investors did not appreciate it and so, when it came, they missed much of the rally in Italy, Spain and the other non-Deutschmark-bloc markets. Those investors who missed the boat last time round might be keener to get involved this time, once their appetite for higher-yielding markets returns.”
At first glance central and eastern Europe might look tempting to convergence hunters. The three most promising countries – Poland, Hungary and the Czech Republic – could offer significant returns but it is thought too early to make convergence plays on them.
Bowler says: “If we hadn’t had Brazil, traders would be looking not just at Greece but at the main emerging European countries. Brazil has obviously cut away a great deal of the appetite that traders had been regaining over the new year.”
Although much early euro trading has focused on how sovereign debt of the 11 Emu participants trades relative to each other, the really big money might be made on trading the debts of the second – and even third – wave of entrants to Emu. Jack Dyson
