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There is much diversity in emerging Europe’s debt markets, finds Matthew Craig

When it comes to the emerging markets, it is likely that most investors consider equities before bonds, and China, India, or Brazil before emerging Europe, Russia and Turkey.
But this could be a mistake, as diversification and positive returns can be found in the region.

“You don’t have to be a particularly clever economist to look at the region and compare it to more established investment grade credit markets and think that the numbers stack up pretty well,” says Hoare Capital Markets’ senior emerging markets fixed income trader, Simon Campbell-Boreham. “If you look at deficits, debt-to-GDP, reserve ratios, labour costs - you realise there is a very compelling argument in favour of Eastern Europe emerging markets. There is also the added safety net of huge quantities of oil and gas in some countries.”

Indeed, many experts observe that government finances in CEE, Russia and Turkey are now much better than in the EU periphery, or ‘submerging Europe’ as one wag put it. But they also insist that it is important to consider the various countries and types of fixed income assets available separately.

“This is an extremely heterogeneous region,” as Alexander Kozhemiakin, director of emerging market strategies at Standish Mellon Asset Management, observes. “And we can identify three different asset classes: dollar-denominated bonds, local currency bonds and local interest rates.” Investors can hold sovereign or quasi-sovereign debt and corporate bonds from issuers in the region, although the issuance of corporate bonds has been patchy as local markets develop.

Russia is one of the main markets and is widely seen as commodity-driven. To some extent it has been penalised recently for slower growth compared to other emerging markets. Five years ago people said the oil price break-even point that Russia needed to see was $20-25/bbl; some now put that close to $70/bbl, according to Campbell-Boreham. “Russia has increased its public spending but if it needed to, it could find a way to adjust the budget without dipping into its savings,” he says. Looking ahead, Raphael Marechal, senior emerging markets portfolio manager at Fisher Francis Trees & Watts (FFT&W), comments: “For Russia, the outlook is bright as long as oil prices remain elevated. Oil revenues have been used by the government to stimulate the economy and Russia will be facing an inflation problem very soon”. This could be exacerbated by the fact there are parliamentary elections due in 2011 and a presidential election in 2012. Consequently Larichev said there are unlikely to be budget cuts in the near future and that Russia will run a deficit in 2012.

Bluebay Asset Management senior portfolio manager Polina Kurdyavko notes that Russian bond issuance is dominated by quasi-sovereigns, with the corporates largely served by local banks. FFT&W’s Marechal makes a similar point: “Russia is more of an equity or a corporate debt market. The sovereign external debt has a very tight spread and the sovereign local debt is very complicated to access as it’s almost traded exclusively by local banks.”

Campbell-Boreham likes quasi-sovereign entities, as they came with an implicit, if hidden, government guarantee. “[Russia’s national development bank] VEB’s bonds pay 100-150 basis points more than Russian sovereign debt but it is almost indistinguishable from the state,” he observes. “That seem a bargain to me”.

Troika Dialog is one of Russia’s oldest and largest investment banks and Oleg Larichev, CIO and managing director for Troika Dialog Asset Management, said Russian corporates are now looking to lengthen their yield curves, with several recent 10- and 15-year issues. “One of the lessons Russian corporates learnt in the crisis was that it is better to have a longer curve and diversify the structure,” he says. “Before the crisis most companies just targeted low interest rates which meant they had very short-term debt”. As a result more Russian corporates are looking to tap the eurobond market for longer duration debt, while continuing to issue shorter dated debt in roubles.

Ukraine and Kazakhstan, though geographically close to Russia, have different characteristics as debt markets. Kazakhstan is seen as having plenty of potential from a fundamental point of view, but it also has issues to deal with, particularly in its banking sector. Looking at corporate bonds, Bluebay’s Kurdyavko says: “Kazakhstan went through a large scale banking sector restructuring, so in today’s market the ability of Kazakh banks to tap the eurobond markets is limited”. But Troika Dialog’s Larichev said he expected to see more issuance from Kazakh corporates from 2011 onwards, once it gets over the bout of indigestion in the banking sector.

On Ukraine, Kurdyavko said corporates have had a tough time in 2008 and 2009 and have been unable to come back to the eurobond market until recently. Larichev said some corporates offered attractive yields, coupled by strong foundations and good cash flows. He picked out chicken producer Mironovsky Vhliboproduct, which issued a bond with a 10.25% coupon that now trades at a 9% yield. “There should be more issues like that coming from Ukraine,” he says. “We have a good understanding of what’s going on, as it is a neighbouring country and offers good value”.

Looking across the Black Sea to Turkey, investors should find much to appreciate. Marechal points out that its fundamentals are in fantastic shape, with a very credible central bank ready to pounce on the inflation that is expected early in 2011. “We will avoid being too long on duration on Turkey in the short-term, for tactical reasons, but long-term will remain long, for strategic reasons,” he says. Historically, corporate Turkey has not issued much paper due to an abundance of domestic liquidity, according to Kurdyavko, but she said it is starting to increase bond issuance in order to diversify funding.

In the core central and Eastern European economies, Poland, Hungary and the Czech Republic are the main markets for investors. Smaller countries such as Romania and Bulgaria, and the region’s ‘frontier markets’ such as Serbia and Albania, fall outside the main global indices for emerging market debt. Here, the story of convergence with western Europe economies has subtly but significantly changed to one of emergence. Schroders’ emerging market debt manager Christopher Wyke says the region’s debt markets participated in the general corporate bond revival of 2009 but adds: “In our view, the risk-reward ratio in corporate bonds at current prices is not so attractive, because their liquidity is not proven in bear markets.”

Currency also comes into play. “CEE currencies specifically benefited when the euro was doing well, but they performed very poorly when it was sold off in the first half of the year,” notes Lombard Odier’s head of emerging market debt Richard Walsh. Damien Buchet, head of emerging market fixed income at AXA Investment Managers, said he took a country-specific approach to the region. On Poland, he says: “It is a very resilient market with high credibility at the main financial institutions, however we have a question over its fiscal and monetary mix”. However, Standish’s Kozhemiakin believes the Polish zloty can strengthen further against the euro, while expressing doubts over the Hungarian forint on the grounds of government policy. “In many cases, shorter duration bonds are a better vehicle than currency forwards for currency exposure,” he concludes.

At present, most emerging market investors take a global view. “Nearly all investors are focused on the entire opportunity set and have not invested in regional funds,” says Mercer senior investment consultant Paul Cavalier. In time, regional mandates may start to appear as investors become more selective, but there is a case for wider mandates. With more pension fund assets going into emerging market bonds, these markets could all play a larger role in the future as pension fund investors diversify and hunt for attractive returns.
 

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