Convergence - who'll be next?
With the EU having warmly welcomed its next 10 members, and bond yield convergence having of course happened some time ago, investors need to get their maps out and check who might be next to be lining up for Europe and to make sure they get in early enough.
As Roswitha Kreller, portfolio manager of Invesco, based in Frankfurt, says: “When the bond yields of a number of eastern European countries were converging in the run-up to EU membership in May, nothing happened for a long time and then suddenly it all went very quickly.”
Kreller suggests that there is good reason to expect much the same sort of pattern with the next round of EU aspirants. She argues that, if investors can correctly assess the likelihood of the individual countries joining the EU and can act swiftly enough, then there are considerable investment opportunities awaiting them.
The speed at which convergence occurred in the eastern European countries which have just become EU members is remarkable: consider Poland where spreads on zloty-denominated five-year bonds over equivalent Bunds collapsed by 800 basis points (bps) in just 30-months between November 2000 and April 2003.
And rapid convergence was also seen in the run-up to the introduction of the euro: 10-year Italian bonds narrowed by some 500 bps in the space of two and a half years.
“The one thing in common is that bond yields had already aligned to European levels only a few months after the convergence process had begun,” says Kreller. “As soon as the market had taken the view that EU and EMU membership would come about sooner or later, yields started to converge. As a rule the process was completed before membership had been contractually agreed, as the market pre-empts expected events and compels investors to act swiftly so as not to miss out on the earnings opportunities arising from the convergence.”
Kreller points out that those countries closest to EU membership will have already seen the most convergence and in the case of Bulgaria, Romania and Croatia perhaps there has indeed been substantial convergence. “Spreads of Bulgarian bonds have already converged significantly. This country is on the right track, in terms of fulfilling the pre-conditions for EU entry, and its bonds are interesting for more conservative investors who can still gain a lot from yield pick-up as well as from continuing convergence.”
The healthier the economy of an EU-aspiring country, then the further the bond yield convergence has gone. For example, Croatia, in better shape than most of the 10 countries which joined in May, according to european commissioner for enlargement, Gunter Verheugen, has a very liquid market and bonds trading some 100bps over euro-zone bonds.
Kreller thinks another three Balkan states – Serbia-Montenegro, Bosnia-Herzegovina and Albania – look interesting just now. “These three have yet to file an official EU membership application, but it is precisely this possibility of EU entry in the long-term – 2030 – which makes these markets attractive.
A major problem for investors is the illiquidity of the markets, but for those speculative investors willing to take the risk there should be good opportunities for investment.”
And for those investors able to withstand considerably higher risk, Kreller suggests Macedonia, which filed its application in March 2004. However, the country must first overcome huge economic and political hurdles, and the market is fairly illiquid. Little wonder that the convergence has yet to begin.
What about the Ukraine? Although EU membership is not on the cards in the near future, the EU has taken up talks in order to improve relations; and when Ukraine launched a euro-bond last year, it was eight times oversubscribed. As Kreller says, high risks in this sort of market are inevitable, but the rewards can be pretty high too.