Turkey 2007: Bumper demand for new linker
Turkey’s local markets have almost fully recovered from their severe sell-off in spring 2006, but the lira and Turkish rates remain first in the firing line whenever sentiment turns against the emerging markets. John Weavers reports.
Turkey suffered disproportionately from the unwinding of carry trades during the emerging market sell-off in spring 2006. The Turkish lira tumbled 30% and local interest rates soared, currency depreciation exacerbating rising inflation and prompting foreign investors to withdraw en masse.
As confidence returned to EM the TL regained its poise to trade back near record highs, although the February/March 2007 correction showed that Turkey was still particularly vulnerable during the EM asset class's periodic bouts of weakness.
The Central Bank (CBRT) fluffed its lines when the 2006 crisis erupted and it failed to signal the sharp rise in inflation in April (a 1.3% jump in April was followed by May's 1.9% increase). In addition, its initial 175bp reference rate hike to 15% failed to restore stability. The government's mishandling of the new CBRT governorship during that period further undermined confidence.
However, the central bank's subsequent policy reforms have provided comfort as the subsequent 225bp emergency hike steadied the TL, while the introduction of monthly inflation reports boosted transparency.
Benchmark April 2008 bond yields soared from a low point of 14.5% (125bp over the 13.25% reference rate) to 24.6% on June 26 2006 (when the reference rate was 17.25%). The reference rate has been 17.5% since a 25bp rise in July 2006 while April 2008 yields had retreated to 18.5% by late April 2007, raising the prospect of rate cuts from summer 2007.
Inflation is set to fall back below 10% thanks to base effects when the 2006 April and May rises fall out of the year-on-year figures, and though the year end 2007 target of 4% (plus or minus 2%) will not be met, the CBRT has reasserted its anti-inflation credentials. (See separate article on the politico-economic outlook for more.)
Meanwhile the Turkish Treasury endeared itself to the markets with the introduction of a five-year index-linked, lira-denominated bond in January. The new issue is linked to Turkish inflation and offers investors some protection against a repeat of the spring 2006 TL slide since currency depreciation feeds through into higher inflation.
The BB/BB– rated bond attracted an impressive book of TL25bn (US$18bn), enabling the Treasury to raise a bigger than expected TL4.1bn from the sale. The 10.0% coupon bond was priced at 101.1 to yield 9.72%, well inside 10% expectations and reflecting investors' willingness to pay a premium for inflation protection.
S&P noted that the sovereign's first visit to inflation-linked securities since 1999 would: "diversify liabilities and, more importantly, the five-year tenor would allow the government to resume its effort to lengthen the maturity structure of its domestic securities".
The average maturity of Turkish government securities has been lengthening, from 18 months in 2003 to more than 27 months in 2005. After the market turbulence that began in May 2006 – and the subsequent rise in inflationary pressures and nominal interest rates – this trend flattened, with the average maturity for 2006 at 27.5 months.
"We expect a continuation in the long run disinflationary trend, projecting a reduction in annual inflation to about 7.5% by year-end 2007, with a further fall in 2008 and beyond," said S&P analyst Farouk Soussa.
Memduh Aslan Akcay, Turkey's director general of foreign economic relations, said of the issue: “The linked bond is definitely a way of sending a bullish message with respect to inflation to the market. Before this deal there was no measure for real interest rate expectations. This issuance also fulfilled the international investor demand for this type of instrument. We would like to continue to issue inflation-linked bond going forward, and make it a part of the borrowing programme."
The Treasury plans to raise approximately TL104bn (US$75bn) in 2007 from the domestic bond market. Issuance in Q1 was high – the Treasury had not expected that level of demand for inflation-linked bonds – so issuance in Q2 through Q4 may see lower roll-over ratios.
The Treasury’s strategy in the domestic market is to extend the duration of its debt and lower the floating-rate proportion. Currently roughly 45% of total government debt is floating rate, and that percentage is decreasing.
Foreign investment in domestic bonds has risen substantially in the last couple of years, to about half of outstandings, excluding the huge holdings of the Unemployment Protection Fund, and foreign buying has kept debt prices firm during recent bouts of market volatility. According to Isil Ozdemir of Is Bank’s client trading team, domestic investors are increasingly investing directly in the government bond market rather than through mutual funds. But they continue to focus on the short end of the market with maturities about three to four months out.
Meanwhile supply in the embryonic lira-denominated, domestic bond market remains tiny. Seniz Yarcan, executive vice-president at development bank TSKB, does not expect many issues in the next couple of years, as long as interest rates remain high.