To date, the focus of most international fixed income investors attention in central and eastern Europe has been on opportunities for exposure to the region through the Eurobond market. "We do have some local currency exposure, but liquidity is a very important consideration," says Christopher Watson, head of research at Finisterre Capital. "One of the big lessons we learned in 2008 was that liquidity has consistently been underpriced."
Many investors learned that lesson painfully in the Ukrainian local currency market. "One of the classic trades that went horribly wrong for some investors in late 2007 and early 2008 was buying Ukrainian government debt that looked incredibly cheap," says Watson."Then the government imposed de facto capital controls and the notional spread differential that investors thought they would be picking up on those 9% bills disappeared."
Bankers and investors agree, however, that the development of local currency bond markets needs to be a priority for the CEE region. "One of the reasons why the region was hit so much harder during the crisis than, say emerging Asia, is because domestic debt markets are so thin," says Marcus Svedberg, chief economist at East Capital, an independent asset manager with Eu4.2bn under management. "The crisis showed how reliant countries like Kazakhstan and Ukraine are on foreign debt."
That is a problem that has clearly been recognised by several CEE countries which have prioritised the development of their domestic bond markets. Initiatives aimed at promoting their growth will be welcomed by overseas investors attracted by the yields available in these markets.
"With G3 yields at close to zero, international investors are definitely showing more of an interest in local markets in CEE," says Gyula Toth, head of EEMEA FI/FX strategy at UniCredit. "They will also be attracted because the correlation of returns are low compared to other assets, which creates some appealing diversification opportunities."
In addition to the yields in the local markets, the potential for CEE currencies is also becoming more attractive to investors from outside the region. "A recent BIS survey indicated that the FX market has grown by about 20% in the last three years and we think that as the economies in the CEE region continue to grow, so too will the FX business and investor interest in the regions currencies," says Mike Hammond, global co-head of capital markets at UniCredit.
As it has in the equity market, Poland has led the way in the development of a formal market for locally listed corporate, municipal and mortgage bonds. The Warsaw Stock Exchange launched its Catalyst bond market, made up of four separate trading platforms, at the end of September 2009.
According to the WSE, "all platforms support trading in non-Treasury debt instruments.... the Catalyst architecture ensures that the market can accommodate issues of different sizes and parameters and serve the needs of different investor groups: wholesale and retail investors, institutions and individuals."
By the end of August, 49 corporate issuers valued at Z18.99bn and 18 municipal bonds worth Z1.74bn were quoted on the Catalyst market. Liquidity remains modest, however, with electronic order book trading in the first half of 2010 amounting to a little over Z250m, according to the WSE.
There have, however, been a number of indications recently pointing towards increased activity and liquidity in the Polish zloty market. Hammond of UniCredit points to the example of the ZL1bn ($320m) five year transaction in September for Polands largest mobile telephone operator, Polkomtel.
Led by UniCredits Polish subsidiary, Bank Pekao, and BNP Paribas, the Polkomtel transaction was issued from the companys EMTN programme and priced at 170bp over the six-month Warsaw Interbank Offered Rate. "The Polkomtel transaction was a highly successful deal and a pointer of things to come in the Polish market," says Hammond.
About 60% of the Polkomtel issue was sold to local pension funds, which Hammond says is also an encouraging indication of the growing maturity of domestic pension funds as supporters of the Polish capital market. "When were talking about local institutional support for the capital market I think we need to distinguish between equity and debt investors," says Hammond.
"The equity market has developed at a much quicker pace than the local debt market. That is largely because the Polish banks have been very liquid and had historically been prepared to provide finance at very competitive rates, which meant there had been less of a need to develop a corporate bond market. That is now starting to change."
Whether it is starting to change or likely to change elsewhere in the region is open to question.
Russia, for example, has yet to develop a meaningful local investor base. Nevertheless, there is an increasingly vibrant market for local currency debt in Russia, driven by corporate borrowers. "There is very good liquidity in the rouble market, which may be one reason why many of the Russian corporates have been slow to tap international capital markets," says Richad Soundardjee, head of CEMEA global capital markets at Société Générale.
"The Russian rouble market is comfortably the most liquid currency market in the region, which is of course linked to the size of the economy and the constant inflows of capital into Russia because of its oil exports," says Toth at UniCredit. "In the spot market as well as in the short-dated NDF (non-deliverable forward) market bid-ask spreads are very narrow."
"Russia will have significant budget deficits to finance over the next few years, and the finance ministry is looking to the domestic market as the key funding source," says Mike Elliff, head of CEEMEA debt capital markets at RBS. "The ministry will definitely be looking at ways to increase issuance in the domestic market, and is also considering the potential of the euroclearable rouble market as a funding source. Currently, local banks are the dominant investors in the rouble market but this is likely to evolve over time."
In other local currency markets, Toth says that at around 7%, Turkish yields remain attractive relative to G3 yields. "The other attraction about Turkey is that in contrast to Russia it has a fairly big government bond market," he says. "That is largely a legacy of the big budget deficit in 2001."
The other CEE country with a meaningful local government bond market is Hungary. "The government bond market in Hungary came to life after a deep market crisis in 2009," says Laszlo Buzas, deputy CEO of the Government Debt Management Agency (AKK). "Today, AKK is selling more bonds at its bi-weekly auctions than before September 2008, regularly offering three, five, 10 and, occasionally, 15 year securities. Close to 94% of our gross financing (consisting of bonds, T-bills and loans) is forint denominated. Domestic bond auctions are well received and, as a rule, oversubscribed. That enabled AKK to increase issuance and to meet its total yearly net bonds issuance target by June 2010."
"Foreign holding of Hungarian government securities fell to 20%-22% in 2009 and continues to fluctuate around that level," adds Buzas. "Banks and institutional investors are the biggest investor group with shares at 32% and 29% respectively."Since the end of 2009 the yield curve has shifted down by approximately 20bp to 60bp depending on the maturity. The present level of around 7% for medium and long term maturities compares well with similar markets in the European Union."