If you're looking for high-yield debt in Europe, you need wander no farther than the Czech Republic. But if you do, you may have to wait in line.
Since the tail end of last year, the Czech Republic has created a boom
market for its Euro-Czech bonds, with some $10 billion to $15 billion issued
in the first two weeks of 1997 alone.
The sudden popularity isn't hard to fathom. It's been tough in the last
six months for European fixed income managers to find somewhere-anywhere-to
put money to work profitably without taking on huge sovereign risk. In the
European Union, the highest yielding bond market is that of the United Kingdom,
with interest rates of 6 percent. A continuing compression in spreads between
the interest rates of E.U. countries is likely to continue in the run-up
to monetary union. So what's a money manager seeking yield and diversification
to do? The answer is, increasingly, invest in the Czech Republic with interest
rates of 12 percent.
The interest in Czech debt has as much to do with its emergent derivatives market as its relatively stable currency and economy. The Czech crown is
a fully convertible currency-a real bonus-and one big reason why the bond
market has been hotter than Poland's this year. Zlotys aren't fully convertible,
and inflation continues to plague Poland, but is under control in the Czech
Republic. Poland missed its 1996 inflation target of 13 percent, while the
Czech Republic clocked in at 9 percent. The Czech crown parallels the Deutsche
mark and the dollar for the simple reason that it is tied to a basket of
65 percent Deutsche marks and 35 percent dollars.
It's a short hop from here to derivatives, which have been available
in the Czech Republic since late 1995 but really picked up steam last year.
It started with foreign exchange, but, says Gavin Moule, an assistant director
at ING Barings in London, "Many more banks have arrived as the short-dated
swaps market started last year." With double-digit yields and a convertible
currency, Czech companies and later supranationals were lured to issue in
Czech crowns and swap straight out for cheap dollar or Deutsche mark financing.
This activity has attracted hoards of European bankers. "You can
see the development because spreads are beginning to narrow," says
Moule. "In May 1996, a bank putting together a one-year swap could
have had a bid/offer spread of 25 to 30 basis points. Today this has shrunk
to 10 basis points. But a Deutsche mark swap would only bring in one or
two basis points."
The market is particularly attractive to supranational issuers. After
swapping back into hard currency, their financing cost is a nifty LIBOR-minus,
with no risk. And the final piece of the puzzle is also in place-buyers
of the Czech crown bonds (those yield-seeking European bond managers).
The Czech government, however, has been a bit worried by the seemingly
hot money flowing into the country, and has widened the band in which the
crown floats around the benchmark basket. That has increased currency volatility
and raised suspicions about the long-term strength of the crown. "People
doing the carry trades have needed to take a longer view," says Nicholas
Gordon-Smith, managing director of Credit Suisse Financial Products in London,
who is responsible for the firm's emerging markets derivatives. That means
that swap tenors are increasing, from under one year to between one and
two years, and that is bringing in new players.
But the open window of opportunity may be closing a bit. Jan-Willem Cramer, senior associate director of Deutsche Bank, says, "The arbitrage opportunity
to get cheap funding may be disappearing as the market is becoming more
mature." Cramer does expect derivatives activity to continue, though
not at such a vibrant level because the sovereign risk isn't that high relative
to other emerging markets.
Equity derivatives is another area ripe for development. But controls
on foreign ownership of stocks will have to be lifted first, and foreigners
will have to be convinced of the commitment of Czech companies to a familiar
corporate governance regime. Past banking crises and investment fund debacles
remain a bit too vivid for many investors to be encouraged about equity