Looking for those eastern convergence plays
Fixed interest investors have found it difficult over the past year to find any real pattern in eastern Europe. Even economies traditionally grouped together have been behaving uniquely.
Andreas Lessmann at Bank Austria in Vienna, nonetheless sees some convergence similarities. “Since we began investing in the region in 1996 we have seen themes similar to those which were identified in Spain and Portugal. A recent risk return analysis we carried out, comparing local currency bonds with Austrian Treasury bonds, confirmed that investment in the former would have produced excellent returns, particularly in Hungary and Poland.
Confirming the uncertainty in the region, Deutsche Bank’s European Treasury analyst John Harrison is not so sure that we are seeing anything significant. “I do not think that we are witnessing a big convergence play here, or at least not as much as we anticipated last year.”
Investors will inevitably be looking at the most liquid markets, and these are made up of the countries which have been performing most solidly in terms of macro economic performance, structural reforms and socio-economic progress. Poland and Hungary head this group, along with the smaller economies of Estonia and Slovenia. The Czech Republic is lagging behind, and most interest there centres on corporate instruments. The reason for this is the low inflation rate, and correspondingly low real interest rates.
Harrison’s economist colleague Laura Papi sees little change imminent. “The Czech government has been cutting rates for two years now, and we are unlikely to see any major policy change with regard to interest rates. There is a possibility of a small hike later this year, but that is likely to be a pre-emptive move to safeguard next year’s inflation target, as this year’s seems to be easily attainable.”
Similarly she expects little change in Poland, except possibly a tiny increase towards the end of the year, whereas in Hungary she believes there is scope for a reduction in rates. “As you can see,” she says, “the countries are behaving differently, although some basic policies are similar. Central banks in both the Czech Republic and Poland have moved their focus to inflation targets. Supply side problems here include the oil price.” She expects domestic demand to pick up in the Czech Republic and to a lesser extent in Poland.
Certainly growth prospects for the region look good, with an average figure of 5% expected across the group of countries highlighted above. Although this will be driven by growth in the Euro-zone, and labour and productivity gains delivered by foreign investment, the exchange rates will also figure in the equation, and Papi believes this remains the single most important factor when predicting interest rates.
Taking the long-term view of convergence, Erik Nielsen, director of new European markets economic research at Goldman Sachs in London, agrees with Lessmann on local currency debt. “Long-term, returns on local currency debt look set to be excellent,” he said. “This is where convergence, in the traditional sense of the word, will be most explicit.” He expects the combination of improving credit, lower issuance as budget deficits shrink, real appreciation, and a declining currency risk premium to yield good returns.
Peter Szopo, managing director of Bank Austria’s East Fund Management in Vienna, agrees that convergence is the main theme for the next three to four years. “We are seeing something similar to what we saw in Spain and Italy prior to their joining the euro, and to a certain extent Greece. We expect things to happen much quicker in eastern Europe, however, certainly faster than in Greece.”
Marguerite Sprasser, who manages the fund’s three portfolios, agrees that Poland is the most liquid of the sovereign markets. “With a possible interest rate hike imminent I would prefer to be on the short end, where we are seeing a 17% yield on a one-year investment, compared with 13% over five years. This means the short end showing a good carry,” she says. Sprasser has little exposure to corporate bonds in Poland, as opposed to the Czech Republic.
“The Czechs have a low budget deficit, and accordingly little government lending. There are a lot of corporate bonds around, but the problem is they are not rated,” she adds.
In Hungary she confirms that the three countries are showing divergent investment trends. “Hungarian yields are much flatter than Poland’s, with the short end yielding 10% as opposed to 8.8% at the opposite end of the spectrum. The latest macro figures also suggest a possible interest rate cut, and so in Hungary I would prefer to go long.”
Szopo expects growth in the region to accelerate this year. “Last year we saw growth for the region at around 4%, but this year I would expect Poland and Hungary to better that by at least one point, and the Czech Republic, although further back in the cycle should still see growth of 1.5–2%,” he said. He also predicts a trend towards lower inflation.
CAIB’s Eastern European analyst Chanat Patel believes that this disinflation rather than a genuine convergence trend is responsible for the current trends in spreads. “We are witnessing long-term downward curves right across the board,” he says.
“Yields in the Czech Republic are around 6–7%, but we see are seeing the spread between the region and German Bunds shrinking rapidly. Yield compression will continue to go down, but there is little room left as we are looking at between 300 and 500 basis points,” he adds.
On the liquidity of the markets Patel points out that up to a year ago the Czech Republic was the most buoyant. “Then yields fell dramatically. The slack was taken up by Poland, where the domestic mutual funds are very active. Treasury Bills tend to be bought and held until maturity. There is little activity in one-year bonds, but two-, three- and four-year bills are regularly traded.”
He points out that foreign exchange restrictions hamper the Hungarian market, along with the rules on paper with less than one year to maturity. “Investors get around this because the wording of the restriction refers to ‘original maturity’ of less than one year. Thus a two-year bond with say three months to maturity can be purchased, as original maturity was a two-year period. With yields much higher in Hungary there is plenty of activity at the long end.”
The Czech corporate bond market is relatively illiquid, says Patel, and Hungary is quiet. “In Poland, however, corporate commercial paper is pretty active up to one year. Companies are finding it an easier way of raising funds rather than dealing with the local banks.”