Time to be realistic on CEE bond markets

  • 2004-03-04
  • By Zigurds Vaikulis
For several years in a row investments in Central and East European bonds, both government and corporate, have yielded 10 percent to 30 percent annually-a return typical for the bullish equity market.

In fact, one can conclude with certainty that the CEE debt market was definitely the right place to be. But is it still?
Before analyzing the current state of the CEE debt market and its perspectives, it is useful to look back at the past to determine what made this segment so attractive and enabled such an outstanding performance. The first and foremost driving factor was the change in global markets environment. At the beginning of the new century, developed nations' economic cycle turned into a recessionary phase, and the world's major central banks started a massive monetary easing campaign. Combined with a downfall in the equity markets and geopolitical disturbances, this turned international investment flows to the safe heaven of debt markets. As the bond prices went up, yields fell further. Soon the returns offered by the high-grade bond segment were no longer attractive to the "new money" flowing into the market, and investors started their hunt for higher yield in lower quality segments.
Another factor was local macro and political developments. CEE countries were steadily progressing toward international organizations-i.e., EU and NATO. In addition, the falling costs of funding not only served as a strong economic development stimulus for the already relatively macro-healthy CEE countries, they also allowed to refinance the debt at lower rates. Political and economic risks lessened considerably, and so did local instruments' risk premiums. Taken together, both factors-internal and external-have allowed the CEE debt market to yield on average 15 percent - 20 percent per annum during the last couple of years.
Within the group, special attention must be paid to Russia - a major out-performer even by CEE standards. The country has managed to regain international investors' confidence, as confirmed by rapidly ascending sovereign ratings. As a consequence, Russia's debt market has enjoyed the strongest credit spread tightening (currently the spread of medium-term government bonds is around 2 percent, compared to 12 percent just three years ago), and those who invested in Russian Eurobonds were lucky (or smart) enough to pocket annualized profits of 20 percent - 30 percent for four years in a row now.
Investors are naturally much more interested in the future - especially those who have missed the rally and must now decide whether they should jump onto a running train. To put in bluntly, one must understand that the salad days are over! The yield differentials between CEE and benchmark bonds are now at the low levels, both by historic and absolute standards, so that the 10 percent-plus profit potential of this market has been exhausted. Also, with credit spreads so low, emerging markets are now in direct dependence on the processes governing developed nations' debt markets. As we all know, the world economy is showing more and more convincing signs of stabilization. By consensus view, this will lead to the end of an accommodative monetary policy stance - not good news for the global bond market.
But there is no reason for pessimism. Any tightening of monetary policy in the U.S.A. is months away, while in Europe we may even witness minor rate cuts triggered by excessive strength of the euro. While current trends persist emerging market debt will still be attractive as it offers somewhat higher current income and allows investors to shorten portfolio duration (sensitivity of bond price to changes in yield). But be careful: in this low interest-rate environment many substandard issuers have emerged; should global rates turn around, they will face difficulties servicing their debts. Therefore, we advice to exercise special care when analyzing the quality of every issuer.

Zigurds Vaikulis is senior financial
analyst at Parex Asset Management.