CEE Bond Markets Offer Attractive Yields
The Central and Eastern European (CEE) local Fixed-Income Markets offer higher spreads and higher yields than their western European neighbours, with many of them already having obtained investmentgrade ratings and providing further favourable prospects.
Many countries in the region have outstanding issues in local currency issues as well as in euros or dollars.
With interest rates in western markets having significantly decreased and with credit spreads for corporate issues having tightened, international investors continue to seek alternative instruments. Demand originally started with the larger new EU member states such as the Czech Republic, Hungary, Poland and Slovakia, where credit spreads for hard currency Eurobonds have tightened to low double-digit figures over the last few years.
A number of countries have outstanding issues of eurodenominated bonds with maturities ranging between five and ten years, but also benchmark issues stretching out to 15–20 years for local currency denominated government bonds. These local currency assets provide a good investment consideration, since they carry substantially higher yields, combined with the fact that the respective local currencies have performed strongly over the past years.
In fact the markets for local currency bonds in the CEE-4 countries (Czech Republic, Hungary, Poland and Slovakia) have been among the most attractive asset classes in recent years, thanks to falling interest rates and appreciating currencies. There were periods when accession-related events triggered a real convergence rally on the markets: for example, after the positive outcome of the Irish referendum in October 2002 and after the formal finalisation of the membership negotiations on the EU summit in Copenhagen in December 2002.
Still Room for Yield Convergence
A popular indicator that measures yield convergence is the so-called “convergence spread”. It reflects market participants’ expectations for the yields of five-year local currency bonds in five years’ time compared to their expectations of German bund yields, derived from the interest rate structure curve. Whereas up until mid-2003 there was a long-term trend towards falling convergence spreads, the correction of exaggerated expectations that the euro would be swiftly introduced in the accession countries led to a rise in the convergence spread, and hence also in yields for long-term bonds. Concerns that the CEE-4 countries will be unable to meet the budget criterion before 2007 meant that, unlike Slovenia and the Baltic states, they would be able to enter the Eurozone in 2009, at the earliest.
Hence, the convergence spread for the CEE-4 local currency bond markets gradually increased for more than a year from the lows in July 2003 to the peaks in August–September 2004. Since then convergence spreads and yields have been steadily falling, hinting on a possible fundamental turnaround. Still convergence spreads and yields are far above the levels of mid-2003, leaving plenty of room for further convergence. In addition the exchange rates have been less volatile and gradually appreciating since EU entry in May 2004.
But how fast will convergence spreads and yields fall to the levels witnessed in mid-2003 and beyond? In order to assess this question one has to become accustomed with the technical proceedings for the adoption of the euro.
Apart from meeting a number of more or less clearly defined criteria (budget, debt, inflation, interest rates) a country that wants to join the Eurozone has to prove its currency’s stability over a period of at least two years in the framework of the Exchange Rate Mechanism II (ERM II).
Thus, if a country plans to join the Eurozone say from 2009, the ECOFIN has to decide on the country’s fulfilment of all criteria at least half a year in advance by mid-2008.
In that case the country would have to enter the ERM II already by mid-2006 at the very latest. All countries now say they want to stay in the ERM II only for the minimum time, for a number of reasons. Thus, the countries will join the ERM II only if they are all but certain that they will be able to meet all criteria for the entry to the Eurozone two years after. In addition, judging from the statements of the European Central Bank (ECB) and the commission, the countries will probably have to stick to the tight 2.25 per cent bandwidth of the original Exchange Rate Mechanism at least on the side of depreciation.
This has a number of consequences. Firstly, the market will already know by mid-2006 and with a high probability if a country will join the Eurozone in 2009, and will likely speculate on it well in advance. Secondly, once a country joins the ERM II it will have to stick with the narrow 2.25 per cent bandwidth of the original ERM at least on the side of depreciation, making investment in local currency bonds a one-way bet as long as interest rates and yields are higher than in the Eurozone. Thus, interest rates and yields will have to fall quickly to levels to or only slightly above the levels in the Eurozone in order to prevent an excessive strengthening of the currencies. Again the market will likely speculate on this, squeezing yields and putting the currencies under appreciation pressure well in advance of the ERM II entry as long as the countries remain on track to join EMU no later than 2010. Thirdly, there is still the risk that some of the countries might again accumulate excessive budget deficits in the course of parliamentary elections in 2006, which could raise doubts on their ability to meet the budget criterion even for a 2010 entry to the Eurozone. In that case a negative reaction of the market would seem all but inevitable.
The Time to Invest Is Now!
The bottom line is that, given current yields and spreads of the CEE-4’s local currency bonds, the market will still deliver outstanding returns – particularly Hungarian and Polish bonds where yields are still the highest – in the next two years as long as the countries remain on track for an eventual entry to the Eurozone by 2010. It is also of particular importance to consider that those gains will be made in the run-up for the entry to the ERM II sometime in 2006 or 2007, by which time most of the interest rate and yield convergence will already have been realised. Even then the “convergence play” will not be over, as new accession countries such as Romania are already in preparation to open up their local currency markets for foreign portfolio investors. So it is not too late to jump on the “convergence train” for the CEE-4 bond markets, and it is almost time to get ready for the next round of convergence with the second-wave accession countries.
Vienna-based Raiffeisen Zentralbank …sterreich AG (RZB) offers access to almost every debt market in the CEE region, trading both issues in local currency as well as those issued in euro or dollar. Regional and local custody services are also provided by RZB.
RZB provides a strong sales coverage for the CEE markets, having excellent access to leading regional institutions and a dedicated multi-lingual sales team located in Vienna and supported by comprehensive macroeconomic and fixed-income research products.
HANS RETTL
RAIFFEISEN ZENTRALBANK
ÖSTERREICH AG
Entry Filed under: Bond Market, Securities