Warning signs appear as Poland’s bond rally shows no signs of running out of steam

“I see froth. I don’t see a classic bubble but the Polish market is certainly starting to look a bit frothy at the longer end. It’s because the yields are being dragged down by the extremely low yields in Germany. Until that changes, Polish yields are likely to remain at rock bottom levels,” he says.

Spiro’s views are broadly shared by debt buying analysts, who are being driven to invest in riskier markets because of the very low interest rates being offered on US , Japanese and German debt. They are being forced to hunt for higher yields, which is prompting a rush into emerging market government debt.

Even exotic destinations like African sovereigns are seeing dramatic falls in yields, often to levels far below their actual level of risk.

The current frenzy for emerging market debt made Timothy Ash of Standard Bank joke about buyers leaping into markets they have never heard of and do not understand in their frenzy to squeeze a few extra points of return.

“It’s set to be a feeding frenzy across EM, and any EM issuer worth its salt, or its rating, is likely to want to get some (as much) cash in the bank. I am tempted to say that almost any issuer, whatever the name, and fundamentals, with a bit of carry could tap this overbaked and pretty ridiculous market. It reminds me a year or so back when I came very close on April 1 to adding a new country, „Vulgaristan” to my regular sovereign weekly. It would no doubt have been AAAA-rated,” he wrote, but then became more serious. “Joking aside, what kind of worries me at the moment is that credit risk seems not to be being priced in at all.”

That desperation to earn more than is being offered by super safe sovereigns actually puts Poland in a very strong position.

A week ago, I took part in a meeting of sovereign debt analysts who were travelling to Warsaw to get a better sense of the trajectory of the Polish economy. I asked them if they felt uncomfortable investing in Polish bonds and if they expected any sudden turn in the Polish market.

“I can see the risks of investing in Poland, but they are lot lower than in truly emerging markets, and I really can’t see the situation changing here for the next few years,” said one, a representative of a large US pension fund, saying that Poland’s status as a member of the EU, and its record of better-than-average economic growth over the last two decades made it a relatively safe destination for the funds he managed.

“Investors are looking for a specific type of sovereign,” says Jamie Reusche of Moody’s, the credit rating agency. “They want an EU member that is not necessarily a member of the eurozone. They do like the institutional framework of the EU, but not being in the line of fire of the Eurozone crisis.”

Other countries like the Czech Republic also fit the bill, but interests rates there are significantly lower than in Poland and have much less liquid bond markets. That leaves Poland with an opportunity to borrow at historically low rates – something that the government has taken advantage of.

Poland has also been strengthened by continuing positive assessment of the state of the economy, with Fitch announcing that it was revising its outlook for the country to “positive” from “stable” because of the success in bringing government debt and deficit under control, the solidity of the banking system and the prospect of continued inflows of EU funds.

That is likely to continue reinforcing the attraction among foreign investors for Polish debt, something that starting to cause some alarm. Marek Belka, the central bank governor, recently expressed concern about the growing number of non-residents in the market; a rapid exit could wreak havoc with the exchange rate.

Recent bond auctions have been oversubscribed, but the danger for Poland is that money that rushed into the country can just as quickly flow out again. Pacific Investment Management Co. (Pimco), the world’s biggest bond fund manager, recently said that it saw better opportunities in emerging markets like Brazil and Mexico in contrast to Poland, where yields have been driven to about 4 per cent – a point less than in Mexico and more than five points lower that in Brazil, according to Bloomberg.

BlackRock, another big bond investor, was very bullish on Poland and the broader CEE region last year, but Beata Harasim of BlackRock said that the company will be much more cautious this year.

“We saw an amazing rally last year, so obviously now is a time to reassess our position,” she said.

The chances of a rapid turn in the market are still fairly low, but low is not zero, warns Spiro.

“Everything is predicated on what happens with the US treasury market,” he says. “If this market turns sooner than we expect, then all bets are off for emerging markets.”