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Euro-Czech Fever

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.

Stable Markets

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).

Hot hands

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 investment.