Treasury Bonds Weather Crises

By Simon Pirani

EU convergence factors, and economics, strengthened the highest-rated eastern European Treasury bonds’ resistance to Turkish and Argentine crisis fallout – and are likely to sustain interest in those markets through the year. Polish zloty-denominated bonds, given upside by high real nominal interest rates that are likely to fall, head the list of investors’ favourites.

Ingrid Iversen, portfolio manager at Rothschild Asset management, said the external debt of such countries as Poland, Lithuania and Romania had been “unscathed” by the initial Argentina-related worries.

This shows a “genuine diversification” of emerging Europe away from the big Latin American borrowers that dominate the emerging markets index, Iversen added. “For eastern Europe, the longer-term issue is convergence, meaning not only EU or EMU membership, but the policies that follow from preparations to join.”

Richard Luddington, md and head of debt origination for the CEEMEA region at JP Morgan, said that the Argentina and Turkey crises had cut back the volume of new issues – and braked crossover investors’ and hedge funds’ moves into emerging Europe debt – but that the underlying trends are positive.

“Scarcity of paper in the emerging Europe region means that it retains a supply-demand imbalance,” he said. “There is investor confidence, particularly around the EU convergence theme.

“The economic slowdown across the world is likely to filter through to eastern Europe, and affect growth rates, and therefore the credit stories. But if western Europe outperforms, that will sustain the eastern European economies better than Argentina or Mexico, for which the US is a crucial export market.”

The special attraction of Poland’s $35 billion domestic debt market lies in the country’s very high short-term interest rates and declining inflation.

David Riley, chief economist for eastern Europe at UBS Warburg, said: “We have felt that, with inflation on a downward path, one should get long on these bonds. Although the market has been pricing some of this in, the five-year yield was offering 8% over bunds.

“Poland’s risk profile is a good one. There are possibilities that inflation will not fall as quickly as we hope, and that the government may decide to issue more zloty bonds. But the event risk is pretty low.”

Ali Chughtai, emerging markets trader at Lehman Brothers, is another zloty bond enthusiast. “The short end of the market has discounted it, but the long end has not. Given the devaluation process and the global slowdown, they have to cut rates. But they did so too aggressively in 1998, and so this time they are holding back.”

Borislav Vladimirov, who trades in eastern European domestic debt markets from Dresdner Kleinwort Wasserstein’s Frankfurt office, said flows to the three front runners for EU membership – Poland, Hungary and the Czech republic – were stimulated both by economic factors and by micro-structural changes in the markets themselves.

“The development of swap markets in Czech and Poland allow more sophisticated fixed-income hedging. More liberalisation is due in Hungary, where the derivatives market lags behind.”

These three countries, together with Slovenia, are really a separate asset class from the rest of emerging Europe. Their debt – which is comparable to that of weaker EU countries rather than Russia, Ukraine or Kazakhstan – is traded less by banks’ emerging markets desks than by Libor traders.

Funds dedicated to convergence credits – mainly based in Germany and Austria, but across the whole of western Europe – have soaked up an increasing proportion of the EU front-runners’ debt. German and Austrian pension funds, driven by low yields across Europe generally, also hold it: they are sitting on Hungarian credits to maturity, helping to make them largely illiquid.

While Croatia and the Baltic states are also EU convergence stories, debt markets in the wild east – which for bond traders comprises Russia, Ukraine, Kazakhstan, Romania and Bulgaria – are subject to entirely different pressures. Eric Fine, emerging market strategist at Morgan Stanley Dean Witter, said crossover investors have “hit the pause button” in these markets, and hedge funds pulled out of them for now, leaving the bonds to be traded by emerging markets dealers, whose numbers are shrinking with banking sector consolidation, and specialist funds.

Russia’s benchmark 30-year dollar-denominated eurobond saw a new year rally – and many bond traders remain bullish about it. Key determinants are evidence of economic growth (albeit modest), high commodity prices and the constant expansion of Russia’s gigantic pool of foreign exchange reserves (earlier this month they stood at $30 billion).

The expected fall in oil prices is as much a factor for bond markets to watch as Russia’s poor relations with the international financial institutions, argued Caspar Melville-Murphy, emerging Europe debt strategist at Dresdner Kleinwort Wasserstein in London. “The single big question is: can Russia’s economic growth outlive a fall in the oil price?”

Iversen of Rothschild’s said the key issues to follow are “oil – definitely – the financial situation, and the improvement we have seen under president Putin,” rather than the latest postures struck in the standoff between Russia and the Paris club of sovereign creditors. “The Paris club dispute revealed that there are still people in Moscow who think it’s OK not to honour obligations – and that is worrying. But the decision made at the highest level was that defaulting is not in Russia’s interests.”

Now, neither default, nor a rapid Paris club restructuring, seem likely. After talks with the Paris club faltered in February, Russian economics minister Aleksei Kudrin gave an unequivocal assurance that payments would be made on time – and since then, they have been. On the other hand, Russia announced late last month that it no longer wants a one-year standby arrangement with the IMF, which effectively sinks any chances of reopening talks with the Paris club for the time being.

Melville-Murphy of DKW said private bond holders hardly welcome the breakdown of the talks. “Russian debt figures look substantially different as long as the Paris club is not sharing the burden with the [private creditors’] London club [which last year agreed on a write-off and restructuring with Russia]. If there are no moves in this direction, people will regard the debt as less attractive at the current levels.”

The temporary freeze of negotiations also torpedoes prospects of a new sovereign eurobond issue this year. It is possible that Russian corporates will come back into the market before the government does: Gazprom, the Russian gas monopoly, has already stated its intention of doing so.

Bulgaria and Romania would both benefit from a return of flows to emerging European markets.

Although a presentation by Bulgarian finance ministry officials to the London market last month met some scepticism in the wake of the Turkish crisis, Vladimirov of DKW said that in the coming year opportunities could open up in Bulgaria’s domestic debt market, while it is difficult to get long-end exposure.

“Depending on a move in interest rate levels, the market could certainly attract investors,” he said. “There is a currency board, a sound banking system and sound banking management. But at the moment the demand for money is low. It is difficult to get long-end exposure.”

That is all assuming, of course, that the market is spared any further shocks like those from Turkey and Argentina that have cast such a shadow over the year so far.

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