Whether at EU summits or in the bond markets, the
central and eastern European sovereigns due to join the European
Union next year have been celebrating their achievements. Record
sizes, low spreads and a wider investor base have enabled them to
act as if they were already members of the club. Neil Day
"It is only today that the Berlin Wall has truly fallen." Dutch prime minister Jan Peter Balkenende's thoughts on the signing in Athens on April 17 of the treaty accepting 10 further countries into the European Union (EU) eloquently captured the spirit of the historic occasion. However, for those states being welcomed into the European family, the signing, if essential administratively, was most important for its symbolism.
December's Copenhagen summit at which the 10 were formally invited to join the EU is widely considered to have been the more crucial occasion, after which the signing ceremony was seen as a mere formality - and turned out to be overshadowed by divisions over Iraq.
Just as important has been the welcome that the countries of central and eastern Europe (CEE) - the eight due to become members next year along with Cyprus and Malta, and those scheduled to join further down the line - have received in the international capital markets.
While the nobility of EU members' ideal of a Europe living "free and at peace" cannot be overstated, the populations of accession states will be looking for more immediate benefits - and in the bond markets, at least, these are already apparent.
At the end of January, appetite for paper from countries joining next year was tested twice in the space of a week with the largest and tightest ever issues for a CEE sovereign. Poland launched a Eu1.5bn transaction - the largest - via Deutsche Bank and JP Morgan, while Hungary issued a Eu1bn deal - the tightest - through Citigroup and Dresdner Kleinwort Wasserstein (DrKW). Market participants were full of praise for the two issues.
"Poland was a great trade," said a banker of the larger issue. "The market environment prior to, and at the time of, launch was fantastic, and the bonds were priced to clear."
Re-offered at 45bp over mid-swaps, equivalent to 61.8bp over the 4.5% January 2013 Bund, the 10 year issue was sold to around 125 accounts, almost all to a pan-European audience. But while the distribution and a three times oversubscribed book was impressive, more pleasing for Poland was the type of investor involved.
"We have seen a change in EU government bond funds looking at the deal," said Jonathan Brown, head of emerging market syndicate at JP Morgan in London. "Poland has become the focus of high grade funds, who recognise that Poland will be the bellwether of the EU accession states."
The importance of the vote of confidence from investors was not lost on Poland's deputy finance minister, Ryszard Michalski. "Poland is already perceived by investors as a de facto member of the European Union," he told EuroWeek. "This was reflected in the interest in the issue, which was widely distributed among investors, both on a geographic and institutional basis."
Hungary also benefited from the increasing number of accounts viewing itself and others as EU member proxies. "We achieved very good results with our first transaction of the year," says Laszlo Buzas, managing director of the Hungarian debt management agency (AKK) in Budapest. "We were able to get distribution to markets that had not been present in our issues before.
"For example, French investors took 15% of the bond, which was a breakthrough. We also had great Benelux placement and Greek investors involved for the first time. The transaction was therefore a success and we will continue this process of widening our investor base through strategic bond issues, with our second of the year being another Eu1bn deal in the autumn."
Phil Bennet, managing director and head of international capital markets at Citigroup in London, highlighted the similarity between the distribution Hungary had achieved and placement witnessed on euro zone sovereign issues. "Of the 91 accounts that participated, we believe that roughly 80% of the names are those that would appear in a book for Greece, Italy or Portugal," he said.
The 10 year deal's pricing of 27bp over mid-swaps also put Hungary a step closer towards EU membership, being just 16bp back from Greece. "We are very well placed between Greece and Poland," says Buzas at the AKK. "If you look at the primary market, we were 16bp back from Greece and 18bp inside Poland, which shows our actual standing in the eyes of investors."
Boosting demand for CEE paper has been the performance of peripheral euro zone sovereigns over the past year. As countries such as Spain and Finland have tightened against France and Germany, investors have sought to enhance returns elsewhere.
"Countries like Hungary are increasingly becoming EMU proxies," says Petri Kivinen, head of EEMEA origination at DrKW in London. "As the CEE sovereigns approach EU and subsequently EMU, you tend to get more and more European government buyers involved. They are basically seeing the likes of Austria, Finland and Greece getting extremely expensive and thus see the upside in buying CEE paper with a little more yield and good prospects of EMU membership during the tenor of their investment."
Following such a strategy is one way that investors can outperform their indices - unless, of course, they are one of the convergence or dedicated emerging market funds still involved in issuers such as Poland.
While enjoying A2/BBB+ ratings and set for EU membership next year, Poland is still included in the JP Morgan Emerging Market Bond Index Plus (EMBI Plus), with a weighting of 2.2%, but, alongside the likes of Argentina and Nigeria and the Philippines, the sovereign is being ignored by investors seeking higher returns.
The EMBI Plus's classification of Poland is increasingly seen as an anachronism. Indeed, if one suggests to certain CEE sovereigns that they are an emerging market name, be ready for a sharp response.
"There are still some people that don't really mind being given the 'emerging' tag, but others, and certainly those that are investment grade, aren't too happy about it," says one banker. "To be fair, they have emerged anyway. They may still be put under the mantel of the emerging markets, but there is so much cross-over buying now that there is no way that you could classify a Hungary or a Poland as an emerging market. You can't even classify Croatia or Lithuania as emerging any more, because with their investment grade ratings the universe of buyers is much wider than it used to be."
Sovereigns such as Hungary are now tailoring their deals for EU government bond buyers. Buzas at the AKK says that Hungary focuses solely on strategic issuance, eschewing opportunism. "We do not do opportunistic issuance but have chosen large sized bond issuance," he says. "By having Eu1bn issue sizes you can easily get into the
major indices and then investors will buy you.
"We already have three bonds outstanding of Eu1bn and two others of Eu500m, which is basically the threshold for these indices."
But while Eu1bn may be large enough for the indices, will the new EU members be able to compete with the Eu5bn plus transactions - the larger through auctions and the smaller through syndicates - that current members are issuing, when their economies and borrowing needs are smaller?
"Liquidity is going to be an issue once the yield differential totally disappears," says one origination official. "Why would you buy a Eu400m Lithuania deal, for example, that is smaller and less liquid than a Eu5bn Austria deal? They are obviously going to have a tough time competing on that basis and it will be some time before Lithuania, with 4m people, will be able to do an issue of comparable size and liquidity as someone like Austria."
However, not all of the new members will face the same challenge. "Hungary is going to get there a lot quicker," says the banker. "It already has a very active domestic market that is very much played by international investors already, so they will clearly achieve that competitive status with the Finlands, Austrias and Greeces of the world."
And low supply can anyway, at times, work in a borrower's favour. "There are two factors that have been working in favour of CEE names," says Stuart Young, head of emerging market debt syndicate at Deutsche Bank in London. "Firstly, that they are sovereign risk, and secondly, that they have scarcity value. Historically, borrowers such as Croatia and Lithuania, have only come to the Euromarkets once a year. Investors are aware that as their annual borrowing requirements are low they only have a one-off option to get in and buy every year.
"That is a very big plus for the European investor base and has accounted for a lot of the spread tightening over the past few years. Investors feel confident that when they buy paper issued by CEE sovereigns the performance will not be affected by continuing supply. If you look at Romania, they launched a three year deal in 2000 at a spread of 550bp over swaps. Three year Romanian paper now trades at around 200bp over. While a lot of this spread tightening can be put down to portfolio managers widening their investment guidelines the issue of supply and demand has also played a part."
CEE sovereigns are also pushing into new currency markets. Last October Poland accessed the sterling market for the first time with a £400m eight year transaction via UBS Warburg. Priced at 115bp over the 6.25% November 2010 Gilt, the deal offered another illustration of investors' comfort with Polish and EU accession state risk. "It really says something when Poland has become acceptable to UK pension funds, for example, who are managing your pension and mine and tend to be quite risk averse," says one banker in London.
Poland also awarded Daiwa SMBC and Mizuho the mandate for its debut Samurai in April and bankers are awaiting a ¥20bn-¥25bn seven year issue in late June or early July. The country will become only the second CEE sovereign to access the Samurai market after Croatia, which has launched four successful issues since 1999 and will return to the market this sumer for around ¥25bn.
Syndicate managers say that Poland would do well to emulate Croatia's success. "Japanese investors tend to be very loyal," says one. "If you return to them once a year, they will normally take their share, and that is what Croatia has enjoyed. Investors have had a good run in Croatian paper and the sovereign has been able to diversify its investor base.
"And on top of that, depending on what you do with the proceeds, the interest rates on offer in yen are quite attractive for borrowers."
You lose some, you win
As well as encountering new investors, CEE officials, such as Buzas at the AKK, are having to get used to dealing with new bankers. "One of the things that says that we are no longer considered an emerging market borrower is the transition that we have made from emerging market desks to European sovereign desks," says Buzas. "They have changed the way that they trade us and we have got new dealers approaching us to get to know our story."
Bankers confirm this. "We are already covering them with the public sector guys who cover the European Investment Bank, Kreditanstalt für Wiederaufbau and the like," says DrKW's Kivinen. "The banks have to evolve the way the credits evolve. It is as simple as that."
One bonus that accessions states are guaranteed to enjoy - and are, in some cases already enjoying - is fees on a par with current EU members.
Although bankers say that the lower revenues are "horrible", they acknowledge that they can hardly demand higher fees when spreads are making it clear that the risks involved in such transactions are so low.
"The fees for the accession countries have basically become EMU sovereign fees," says one syndicate manager. "That has unfortunately become a standard. It's good for the borrowers and bad for the banks, but that's life."
Buzas is keen to focus more on the message that the new situation sends out, rather than on any economic benefit. "It is not the question of saving money, but the recognition of Hungary's status as a would-be EU sovereign that is the main message," he says.
But while those sovereigns set for EU membership next year - rated in the triple-B to double-A categories - may not prove as juicy for lead managers and investors as before, there are still rich pickings to be had. Further down the EU queue, Bulgaria, Croatia and Romania are aiming for membership in 2007 and, with their single-B to triple-B ratings, still offer yields well into the triple-digits.
And as higher rated sovereigns move into the EU fold, the extra attention that the three are attracting is helping their spreads tighter. "If you look at Romania, they did a three year issue back in 2000 that was trading at around 550bp over swaps and is now at around 250bp over," says Deutsche's Young.
"They have benefited as investors have moved down the credit curve. So while there is no question that their credit quality has improved, the issue of supply and demand has also played a part."
Other bankers share this view. "The levels of Hungary, for example, are getting too tight for many of the convergence funds and they are seeking higher yields, so they are looking further east," says one banker. "And they don't have to look very far - to Romania, Bulgaria or Croatia - to get a pick-up in yield for, in my view, very little added risk."
And although question marks still remain about the Bulgarian and Romanian economies, analysts are optimistic about their chances. "For Bulgaria and Romania, the 2007 target is realistic," says one. "They still have a few years to go and unless something goes horribly wrong politically they will get there. The economic revival is unstoppable and at this stage the political side appears to be so too."
Part of the analyst's conviction is a result of the view that a trickle-down effect is in play among the former communist states.
"People are already asking whether the Austrians or Germans should have goods manufactured in places like Hungary or Poland, not to mention the Czech Republic, where labour costs are getting higher," he says. "They are therefore relocating to places like Romania. That is a natural process and will bring prosperity to these countries."