Scarcity value is an elusive commodity for sovereign borrowers these days, especially for the beleaguered governments of western Europe. But in vivid contrast to many of their counterparts in the eurozone, a number of sovereign borrowers in central and eastern Europe have been able to capitalise on their relatively low indebtedness and modest overall funding levels.
Those low borrowing requirements, say bankers, have meant that a handful of CEE sovereigns have enjoyed the best of both worlds, maintaining their scarcity value while simultaneously being able to issue liquid benchmarks across the yield curve.
Poland, predictably enough, provides the best example. "Poland has a huge advantage in terms of its low indebtedness and modest overall funding requirements," says Clemens Popp, global head of financial and public sector entities origination at UniCredit in Munich.
Poland began 2010 with a projected funding requirement of Z196bn, the foreign currency component of which was Eu5.5bn (equivalent). Those projections were made, however, on the basis of very conservative growth expectations, with the budget pencilling in GDP growth of 1.2% in 2010. Now, the government is expecting growth to come in closer to 3%, which in turn will bring the total funding requirement down from initial forecasts.
Meeting that modest funding requirement is made easier because in contrast to a number of western European sovereigns, for example, Poland has the luxury of a strong and stable domestic investor base, which typically allows the government to raise about three-quarters of its annual financing needs in the domestic market.
"Among CEE countries, Poland stands out for the size of its domestic pension fund industry," says Christian Reusch, global head of debt capital markets at UniCredit. "From an investment perspective local pension funds in Poland focus mainly on Polish zloty."
Internationally, meanwhile, the structure of the investor base for the most developed CEE economies, notably Poland and the Czech Republic, has changed markedly in recent years, with EU accession and convergence with the eurozone removing several CEE sovereigns from the radar screens of most dedicated emerging market investors.
"Transactions from borrowers such as Poland and the Czech Republic are now mainly sold to western European and US insurance companies and fund managers," says Reusch. "They clearly have access to high quality pan-European accounts, with little involvement from emerging market accounts. It is ultimately a question of spreads, and with a sovereign like Poland issuing at high double-digit spreads this is no longer of interest to emerging market investors compared with coupons of 8% or 9% that some CIS borrowers are paying."
Poland has taken advantage of this situation, easily covering its entire funding requirement for the entire year by the end of July. It hit the ground running in January, extending its yield curve to 2025 with a spectacularly successful Eu3bn 15 year benchmark via HSBC, ING, Société Générale and UniCredit.
Priced comfortably below whisper guidance, at 148bp over swaps, the Polish benchmark, which was its biggest transaction for almost four years, pulled in orders of about Eu7.5bn from investors in 34 countries, with almost half of the bonds sold to fund managers.
Polands 2025 benchmark built on the sovereigns track record of developing a long and liquid curve in euros, with transactions such as its Eu500m 50 year deal in January 2005 having positioned it for many years alongside core eurozone sovereigns such as France.
"Poland is a good example of a borrower that has been very prudent in managing the tenor of its liabilities," says Andrew Dell, managing director and head of CEEMEA debt capital markets at HSBC. "It has been careful not to overload the short end of the yield curve, which some western European sovereigns have done.
Reusch at UniCredit echoes this view. "Poland has been very successful in building and extending its euro yield curve," he says. "The 2025 transaction was a blow out which clearly showed how much sentiment has changed towards Poland. A long-dated Eu3bn deal at such an attractive spread level would not have been possible in the last quarter of 2009."
Another indication of the strength of investor demand for exposure to the Polish credit came in March, when in a fragile market a book of Eu2bn was built within three hours for the sovereigns Eu1.25bn seven year bond led by Barclays Capital, Citi and HSBC. Poland priced its March deal at 100bp over swaps, which was at the bottom end of the whispered range and in line with guidance.
Relative value perceptions changing
The Czech Republic has also been able to exploit its scarcity value to print outstandingly successful benchmarks in the euro market. It rounded off its funding for 2010 with a Eu2bn 2021 benchmark in early September, pricing at 105bp over swaps, compared with initial guidance of 115bp-120bp over.
With spreads in the primary and secondary markets grinding relentlessly in for the best sovereigns in the CEE region, an intriguing relative value dynamic is starting to take shape across Europe, which at some stage may present a new challenge for borrowers such as Poland and the Czech Republic. "At the beginning of July we saw the Czech Republics CDS trading only 20bp or 30bp north of France, and Czech and Poland are already trading well inside Italy in secondaries, let alone compared to those of Portugal and Ireland," says Marc Giesen, head of CEEMEA debt origination at RBS. "So the old perceptions of relative value in western and eastern Europe have clearly changed dramatically."
That relative value dynamic, say some bankers, may soon lead some of the issues from the more beleaguered eurozone sovereigns to start offering irresistible value compared with some of the newcomers to the EU from central and eastern Europe.
Another competitor to eurozone sovereigns in euros is Slovenia, which launched a Eu1.5bn 10 year bond in January via Calyon, Deutsche, JP Morgan and Nova Ljubljanska Banka. Having pre-funded much of its 2010 requirement last year, Januarys euro benchmark covered most of Slovenias financing need of Eu2.2bn in 2010.
Nevertheless, it still left room for the government to return to the euro market in March with a Eu1bn five year issue led by Abanka vipa, Commerzbank, RBS and SG CIB. The five year issue was priced at 37bp over mid-swaps, compared with mid-swaps plus 68bp for the January issue.
"The successful launch of the new benchmark not only further proves the republics high credit quality, solid fundamentals and rarity values," noted SG at the time. It also "further contributes to positioning the Republic of Slovenia as a well established European sovereign issuer."
For all the success of these issues, bankers say that the euro market is not necessarily open to all the regions sovereign borrowers. "Outside the highest rated central European sovereigns, much of the issuance weve seen so far has been in dollars," says Mike Elliff, head of CEEMEA debt capital markets at RBS in London.
"The euro has been a more complicated market, in part because European investors are more sensitive to headline and refinancing risk."
Borrowers such as Poland enjoy the luxury of choice in the international capital market. "When youre talking about a huge economy raising Eu5bn it is not hard and allows Poland to diversify into a number of different currencies," says UniCredits Popp. "Its annual international funding requirement is large enough for it to print one euro benchmark per year as well as transactions in currencies such as dollars, Swiss francs and yen. That has allowed the government to cultivate a broad international investor base."
For Poland, this is nothing new. In the yen market, for example, it has acted as something of a standard-bearer for CEE borrowers for many years. It launched its debut Samurai transaction in 2003 and has been a regular issuer in that market ever since. Its ¥44.8bn deal last November was the first sovereign Samurai deal of 2009 and the first from a CEE borrower since Hungary and Poland itself tapped the market in 2007.
The joys of dollars
It is in the dollar market, however, that the core EU members of the CEE have been most active in extending and diversifying their investor bases over recent months. "Borrowers like Poland and the Czech Republic that used to sell a lot of their bonds to institutions such as German Landesbanks saw much of their European investor base fall away as a result of the crisis," says Jonathan Brown, head of European credit syndicate at Barclays Capital in London. "A number of borrowers in CEE have responded by turning to the dollar market, where appetite among US high grade borrowers has been high often on a scarcity value basis."
Dollar funding, says Brown, has offered CEE sovereigns the allure of a deep and largely untapped investor base, combined with competitive all-in pricing and access to a range of maturities stretching out to 30 years. "CEE sovereigns are accessing dollars at the same rates as euros, and theyre attracted by the size of the investor universe in the US that is prepared to look at CEE borrowers," he says. "In euros, borrowers such as Poland, Croatia, Lithuania and the Czech and Slovak Republics have moved into the rates-style investor base in which competition is intense. In many cases they are finding that dollars are more advantageous in terms of execution, size and spread."
This was certainly true in the case of Polands $1.5bn five year global led in July by Barclays Capital, HSBC and Nomura, for which demand reached $8bn in less than an hour. Priced at 215bp over US Treasuries, which represented a modest new issue premium, 50% of the Poland global was placed with US investors, with orders booked from 335 accounts in 30 countries.
Another central European sovereign that has successfully tapped the dollar market in recent months is Croatia, which launched a debut $1.5bn 10 year Reg S/144A deal led by Barclays Capital, Citi and JP Morgan in October 2009. When it launched its $1.25bn 10 year transaction via Barclays Capital, Citigroup and HSBC in July, Croatia was credited with re-opening the market for emerging market sovereigns which had been closed for the previous two months. Croatias benchmark was priced at 381.3bp over US Treasuries and generated demand of $2.8bn, with 53% of the bonds placed with US accounts.
Among other front-line CEE sovereigns, Hungary has also found the dollar market to be a fertile source of deep and competitive funding in 2010. Since its IMF-led $25bn bailout in October 2008, Hungary has been rebuilding its relationship with investors.
Its first internationally-targeted bond issue after the bailout was its Eu1bn five year deal in July 2009 led by Citigroup and ING, priced at mid-swaps plus 395bp. In January, Hungary returned to the dollar market for the first time in five years, printing a $2bn 10 year bond which was led by Citigroup and Deutsche and more or less satisfied the governments entire international funding requirement for 2010.
The Hungarian benchmark, priced at 265bp over US Treasuries, generated total demand of $7bn from 200 accounts.
Real money investors dominated placement, with asset managers accounting for 82% of distribution. US investors bought 55% of the Hungarian bond, with 33% placed in the UK.
"The last time the Republic of Hungary issued a dollar-denominated bond was in 2005," says Laszlo Buzas, deputy chief executive of the Government Debt Management Agency (AKK) in Budapest. "Given the heavy issuance schedule in the euro market in January 2010, the dollar was a natural alternative. The outstanding response to the deal, as well as the quality of the order book and the secondary market performance confirmed that this was a great deal for the republic."
In terms of future issuance, the IMF programme has given Hungary some breathing space, but sooner or later it will need to return to the market.
"This has been quite a light year for Hungary," says Giesen at RBS. "Next year will be a different ball game altogether with some chunky redemptions in the pipeline."
"For refinancing debt maturities (excluding T-bills), the republic needs approximately Eu7bn-Eu8bn annually in 2011-2012, split between Hungarian forint bond maturities of Eu3.5bn, international bond maturities of Eu1.5bn to Eu2bn and a repayment to the IMF/EC of Eu2bn-Eu3.5bn," says Buzas.
"We dont expect any internationally-targeted issuance out of Hungary for the remainder of 2010," says Popp at UniCredit. "We expect Hungary to be back in the market in 2011, although its not yet clear whether this will be with one benchmark or two. It depends on what they can achieve in the local market, and on the revenues they can generate through their ambitious privatisation programme."
Giesen at RBS says there are some parallels between Hungary and Romania, which successfully printed a Eu1bn five year issue in March via Deutsche, EFG Eurobank and HSBC at 268bp over swaps, but that Hungary "clearly has a larger debt quantum to consider".
The order book for the Romanian benchmark looked impressive enough, reaching Eu5bn. The strength of demand, however, reflected a chunky new issue premium of 25bp, and events since the spring have suggested that investors were right to be cautious about the outlook for Romania.
Facing a deficit projected earlier this year to reach 9% of GDP in 2010, Romania has had to swallow some bitter medicine in exchange for the Eu20bn bailout from the IMF and the EU it signed in April. Romanias bailout conditions included a cut in public wages of 25% and an increase in VAT from 19% to 24% aimed at helping to scythe the deficit to 6.6% of GDP by the end of 2010 and to 4.4% at the end of 2011.
Investors in the domestic government bond market have not been spared as Romania continues to take the axe to its deficit, effectively imposing a yield cap on T-bills and T-bonds of 7%. One obvious consequence has been that, in contrast to a market like the Czech Republic where domestic auctions have been very comfortably covered in an environment of tumbling yields, Romania has repeatedly struggled to drum up sufficient demand for government paper. In July, for example, auctions that planned to raise L4.6bn raised only L1.38bn.
To date, support from the IMF and the EU has bought Romania enough time for it to be able to stick to its guns in terms of capping yields. As RZB comments in a recent research note, "over the last few months, the government had a large room for manoeuvre to reject investors bids because of the money it raised from the IMF and the EC in the second half of 2009 and in Q1 2010."
That room for manoeuvre, however, has a limited shelf life and may already be at or near its sell-by date. As RZB says, "the governments gross funding needs for the second half of 2010 remain high. It has to finance the budget deficit for the second half of the year, which is high, and to roll over/ensure financing for the existing maturing debt, which is also high."
That explains why Romania has laid the groundwork for a return to the international market in the next few months, recently mandating Erste Bank and Société Générale as arrangers of its EMTN programme, from which it plans to raise some Eu7bn. "If the EMTN programme is finalised sooner rather than later we may see a transaction from Romania before the end 2010 but the likelihood is for a deal at the start of next year," says Popp.
Not just mainstream names
Among some of the more exotic Balkan-based borrowers, the BB/BB+ rated Macedonia launched a debut Eu175m 3-1/2 year bond at the end of June 2009. Led by HSBC, Macedonias inaugural Eurobond was priced with a juicy 9.875% coupon and attracted orders of about Eu200m. That deal has not yet opened the floodgates for other new borrowers from the Balkans in 2010.
"Sooner or later we will definitely see issuance from borrowers such as Albania, Montenegro, Serbia and others, which are constantly sending out RFPs," says Popp. "But here we are talking about borrowers that will be issuing in volumes of between Eu50m and Eu250m. Were not talking about benchmark transactions, although given the size of these economies a size of this kind is definitely sufficient."
Beyond the sovereign issuers in the region, the universe of CEE borrowers accessing the international bond market has been slow to expand and diversify. Among financial institutions, Slovenias Export and Development Bank, Sid Banka, made its debut in the Eurobond market in April, with a Eu750m five year transaction via Deutsche Bank, HSBC and UniCredit, which generated an order book of Eu1.2bn. That allowed for pricing to be at the low end of its guidance range of 63bp-68bop over swaps.
It also helped to add some diversification to the regions bond market. "In the past, the only country in which we have seen significant bank issuance has been Hungary, chiefly from OTP and FHB," says UniCredits Reusch. "Weve also seen selective supply from Slovenia, with deals such as Sid Banka and the government guaranteed deals last year from Nova Ljubljanska and Abanka."
The potential for more financial institution issuance from central and eastern Europe is, however, naturally restricted. "Although we have seen rising issuance from the banking sector in Russia and Turkey, elsewhere in the CEE region financial services are now largely under control of foreign parent companies, which is why were unlikely to see them issue in international markets in their own names," says Reusch.
Corporates and high yield too
Corporate issuance has also been thin on the ground in CEE, and it is unclear how much of the existing supply should count as emerging market debt. In April, for example, the Hungarian oil and gas group MOL returned to the market after a five year absence with a Eu750m seven year bond via BNP Paribas, Deutsche Bank, RBS and UniCredit that was priced within guidance at 315bp over swaps. "We had an order book for the MOL transaction of Eu5.6bn from more than 400 accounts," says Reusch.
"There was a tremendous level of over-subscription from investors in the UK and Ireland as well as in Germany, Austria, Switzerland and CEE."
Marc Giesen at RBS, says that the MOL deal was driven principally by the borrowers pursuit of investor diversification. "MOL was looking to diversify its funding away from bank loans," he says. "A syndicated loan would typically have involved a maximum of 40 participating banks, whereas one of the key positives for MOL was that there were 435 investors in the book. So the borrower was able to multiply the number of its lenders or investors and at the same time extend its duration, because this was a seven year deal, whereas bank lending would not have gone beyond three or maybe a maximum of five years."
The other most notable corporate issuer from the central European energy sector is CEZ. The A2/A- rated Czech company has, however, long since been regarded less as an emerging market play and more as a core EU utility.
Indeed, when it priced a Eu750m 2025 year transaction in April via Bayern LB, Erste, HSBC, Société Générale and UniCredit, CEZ was credited with re-opening the 15 year segment of the corporate market after six months of inactivity. "If you look at the CEZ 2025 transaction, more than 95% of the bonds went to western European investors who are also buyers of Eni or RWE," says UniCredits Reusch.
Fund managers bought 44% of CEZs April transaction, and this share climbed to 75% when the utility returned to the market in June with a Eu500m 10 year deal via Citi, Crédit Agricole, Deutsche, Erste and RBS, which was priced at 167bp over mid-swaps.
While it is clear that a credit like CEZ belongs firmly in core western European credit portfolios, the target investor base for many other corporate borrowers from the region is less straightforward to define. "The question that arises when a CEE corporate issues a bond is whether it goes into an emerging market or a high yield basket," says Dominique LeMaire, head of high yield and hybrid capital markets at UniCredit.
"The distinction between the two is becoming more and more blurred, because over the last six months the audience for these borrowers has been investors across the board looking for yield."
Potential high yield corporate borrowers from the region, says LeMaire, typically fall into one of two camps. One camp is populated by sub-investment grade credits from investment grade countries such as the regions EU members, like the Czech Republic. "While a borrower like CEZ is clearly in the investment grade bracket, within the Czech Republic, which is single-A rated, there is a range of companies that are truly sub-investment grade because of credit rather than sovereign risk considerations," says LeMaire.
The other camp, says LeMaire, is made up of companies that are based in less developed economies and are therefore sub-investment grade because constrained by their sovereign rating, irrespective of their own credit quality.
Of much more appeal to investors in search of higher yield in the region will be transactions such as the Eu400m seven year deal led last December by BNP Paribas and UniCredit for Croatias largest food retailer, Agrokor. Offering a coupon of 10% and a re-offer spread of 827bp over the 4% 2016 Obl, the Agrokor transaction generated demand of Eu700m from a broad range of investor types across a number of countries. While about a quarter of the demand came from local investors, some 30% of the bonds were placed in the UK, with Austrian accounts and Swiss private banks also strongly supportive of the deal.
"The Agrokor transaction was a case in point about the blur in the delineation between core high yield investors, emerging market specialists and even some investment grade accounts," says LeMaire. "Agrokor is a double-B credit located in a country which is a long way from joining the EU and is clearly an emerging market." That much was obvious enough from Croatias sovereign CDS spreads at the time of the Agrokor transaction, which were trading some 100bp wider than Poland.
The Agrokor credit therefore sits demonstrably in high yield territory. "If Agrokor was, say, a German company it would be a classic German high yield issuer," says LeMaire. "But when we placed the Agrokor transaction there was demand from managers placing orders for a number of their own funds specialising in different mandates or strategies.
"For example, we saw hedge funds putting some of the bonds into their high yield-focused funds, some into their emerging market-focused products and some into investment grade crossover-focused funds simply because it fell into the parameters of so many different mandates."
That diversified demand, says LeMaire, carried the benefit of generating price tension. "In the same way that investment grade issuers are able to create price tension between the dollar and euro markets, corporates in the CEE region will increasingly benefit from the same dynamic between different investor bases," he says.
Another rare but notable recent high yield bond issue from the region which was successfully launched at the second time of asking was the Eu475m eight year deal from the Czech mining company, New World Resources (NWR), in April. NWR had been forced to postpone a Eu700m issue in February when markets took a sudden turn for the worse. But when the deal resurfaced via Goldman Sachs, JPMorgan and Morgan Stanley, it was priced at 551bp over Bunds with a coupon of 7.875%, and generated orders of more than Eu2.5bn.
Although borrowers such as the Ukrainian egg producer, Avangard, were readying new transactions in the late summer, the outlook for supply of high yielding corporate material from the CEE region remains muted. "I think issuance will be led by refinancing," says LeMaire. "Borrowers will be prepared to bear the cost of carry to use this rate environment to refinance bank facilities.
"Well also see shorter dated maturing bonds being refinanced with longer dated issuance. And we are seeing a pick-up in M&A driven issuance, with sponsors looking at the possibility of expanding their portfolios."
Need for a longer term view
Corporate activity, says Giesen at RBS, may start to filter through as capex programmes that were a casualty of the crisis are dusted down and revived. "During the crisis it was striking how quickly and decisively some of the larger companies in the region put a stop to their discretionary capex programmes," he says. "Those decisions were taken back in 2008 and 2009, so I would expect many of these investment programmes to reappear on companies agendas beginning in 2011. That may mean that we start to see some new names coming to the market next year."
Others are optimistic about the longer term potential for corporate issuance from the CEE region. "I am surprised that we have not yet seen much corporate issuance from Russia," says Richad Soundardjee, head of CEMEA Global capital markets at Société Générale Corporate & Investment Banking. "I would expect to see more issuance from the metals and mining sector as well as oil and gas, driven by a mix of refinancing, M&A and capex requirements."
Mike Hammond, global co-head of capital markets at UniCredit says M&A will underpin more opportunities in CEE, adding to the diversity of supply across the region. "We firmly believe that the M&A environment will improve, not just internally but also on a cross-border basis," he says.
"The issue of funding for borrowers in the CEE region will ultimately be related to banks funding levels which are creeping up. So our feeling is that for corporate borrowers there will be a natural progression away from loans and towards the capital market."
Those opportunities, says LeMaire, will be dispersed across the CEE region. "Were looking at opportunities in the more central European countries of the CIS where investors are becoming more comfortable with the macro-economic outlook," he says. "Investors are looking for good credits that simply happen to be in the wrong postcode in terms of the sovereign rating, and for relatively highly levered credits in the stronger postcodes.
"Given the number of single-A rated countries that are on the periphery of the EU, the opportunities for growth in the high yield market are tremendous."
Allied to this scope for more diversified supply, thinks LeMaire, may be the potential for corporate issuance from the region in a wider range of currencies. "Because many of the economies in the region are commodities-based, issuance to date has tended to be mainly in dollars," he says. "It will be interesting to see how euro issuance develops over the next two to three years."There is a strong demand for euros which may be an attractive alternative, especially for issuers looking for longer dated funding."
Investor profile: Finisterre Capital CEE Fixed Income
He was not disappointed. Watson is also an emerging market fixed income specialist with about $1.2bn under management across four products, the Sovereign Debt Fund, the Global Opportunity Fund, the Credit Fund and the Emerging Markets Fund.
In 2009, Finisterres Sovereign Debt Fund, which was 2.1 times leveraged, was a stellar performer, generating a return of 50.8%, much of which was driven by the funds exposure to CEE Eurobonds. "Most emerging market long-only indices were up about 28% last year and as we had a net long of 0.7 we generated about 22% of our performance from being long and the remaining 28% from our long/short exposure," says Paul Crean, Finisterres chief investment officer.
"At the beginning of 2009 it seemed to us that pricing levels in emerging Europe, and especially in the CIS, were discounting Armageddon," says Watson. "Investors overall results last year therefore depended on how quickly you bought into the recovery story, which we began to do early in 2009."
That, says Crean, meant focusing Finisterres long bias on economies that had been especially hit by the sell-off in 2008, such as Kazakhstan and Russia. "Kazakhstan was dragged down by the problems in its banking sector, and although the government has no Eurobonds outstanding on which it could default, this did not stop five year CDS spreads from widening out to 1,700bp at one stage," says Crean. "Because the curve was inverted, one and two year spreads widened out even further, reaching close to 2,000bp.
"To warrant those levels, Kazakhstan would have had to issue a new Eurobond and promptly default on the first coupon. But banks and other risk-takers were using the front end of the CDS market to hedge Kazakh bank and other credit risk. When liquidity in the bank names dried up the only way they could appear to be covering their risk was by buying protection in the CDS market."
Crean says the phenomenal level of risk aversion in 2009 also created a number of opportunities in the Russian market. "In the case of VTB Bank, at one stage in early 2009 the bond-CDS basis reached 700bp," he says. "That meant that even if you werent particularly bullish on VTB you could earn 7% a year with a fully hedged credit position."
The reversal of many of the most extreme pricing distortions in the region in 2009, says Crean, means that opportunities as enticing as some of those that arose last year will be more difficult to find now. "In 2008 it was all about the destruction of asset values, and 2009 was the year of recovery," he says. "But 2010 has been much more of a trading year, when sentiment has moved from deep pessimism to extremes of optimism."
Over the short term, Crean says that there may be a number of macroeconomic and supply-related headwinds for investors in the CEE region. "The new issue calendar is potentially quite busy, and at these overall yield levels corporate and sovereign treasurers may be tempted to issue long dated bonds," he says. "That may make this a good time to have a more defensive strategy in the region."
Over the longer term, however, Crean believes the supply-demand dynamics in emerging markets in general and in CEE in particular continue to be compelling.
"The US pension fund industry has assets of about $3.8tr," he says. "We estimate that at the start of this year no more than 0.5% of that was invested in emerging market debt. In the UK, allocations to emerging market debt are even lower. But when you ask these investors where they see global growth coming from in the next five, 10 and 20 years, they all point to the potential of emerging markets."In other words, says Crean, there is a large mismatch between investors expectations and allocations. If and when the two become more closely aligned, the acceleration in the flow of funds into emerging markets can be expected to be dramatic.