Turkey 2006 - Improving fundamentals

IFR Corporate Hybrid Capital 2006
10 min read
Emerging Markets

Spread convergence accelerated through 2005 and early 2006, and despite the now traditional March correction, investors continued the strategy of swiftly buying into emerging market sell-offs.

A much improved economic record led by falling interest rates and hefty primary budget surpluses has specifically supported Turkish assets, as did the start of EU accession talks last October after a long struggle. But while high beta Turkey did manage to outperform most of the EEMEA pack (notably Russia), Latin American credits – boosted by a series of buyback announcements – have posted larger gains. (See separate article on political and economic developments in this report.)

Greg Kronsten, Turkey economist at Commerzbank, sees potential for Turkish outperformance against the rest of the EM asset class whether the overall EMBI+ narrows further or widens. Upgrade potential and the ongoing reduction in borrowing costs are improving the positive technical position, with the share of interest payments as a percentage of total budget revenue plunging from 59% in 2003 to 34% last year, and below 25% this.

Kronsten does not view the current account deficit (CAD) as a significant problem even though it exceeded 6% of GDP in 2005. He points out that last year's widening was almost exclusively a result of higher oil prices while it far from unusual for a strongly growing industrial economy to run a deficit as it sucks in capital imports.

Instead he is more concerned about reform fatigue as indicated by the continuing delay in securing parliamentary approval for IMF-required social security reforms that were meant to be passed last October. However, he notes that when push comes to shove, parliament can get its act together, as it showed in 2003, when rushing through a batch of EU-related reforms in one go.

In the primary debt market, Turkey's hopes of repeating last year's lauded issuance strategy started well, when the Treasury took out a large chunk of 2006's US$5.5bn Eurobond funding requirement with a US$1.5bn 30-year print on January 4 that drew plaudits across the market.

As a rule of thumb, Turkey kicks off the year with a longer-dated US dollar deal before alternating between euro and dollar issues. Consequently Turkey's second Eurobond of 2006 was a €750m 10-year offering that was priced in line with 5.05% guidance at a difficult time for the euro market. EU convergence players and European government bond investors were at the fore of what is primarily a buy and hold issue, while investment-grade money also participated fully thanks to Turkey's status as a Zone A country.

Turkey has now raised 44% of its international bond issuance target for 2006, and the Treasury will continue to monitor the markets for further supply opportunities including a possible tap of the new 2016s later in the year to take the issue up to €1bn.

Scope for a buyback?

Speculation of a Turkish liability management operation has resurfaced following local press reports that the Treasury is planning to buy back bonds maturing between 2007 and 2010 and swap them into longer dated, 2015–2030 paper.

Bankers agree that an exchange – whereby inefficient short-dated, high-coupon bonds would be exchanged for longer-dated, lower-coupon paper – makes a lot of sense for Turkey. The short-term structure of Turkish debt leaves the country vulnerable to external shocks.

The majority of Turkey's most expensive issues reside at the short end, with 10 high-coupon Eurobonds, maturing between 2007 and 2010, in line for exchange (six US dollar bonds and four euros). They include the US dollar December 2008s and June 2009s with 12% and 12.375% coupons, respectively.

Several investment banks have discussed exchange possibilities with Turkey after parliamentary approval was secured in March 2005 allowing the Treasury to undertake Eurobond swaps. But the matter was subsequently put on the back burner as the authorities focused on raising new funds.

Most origination desks do not believe an exchange is imminent since the groundwork to put together such a swap usually takes three to four weeks. That said, the Treasury would be keen to keep its plans confidential before hitting the market, and if it succeeds in maintaining secrecy, an exchange could be announced and executed very quickly.

Inevitably the Treasury gives little away. Memduh Aslan Akcay, director general of foreign economic relations, would only confirm that a debt exchange transaction: "has been on the agenda for some time, and that the Treasury will continually assess the value in this transaction and act if and when it fits our objectives."

But the consensus view in the market is that Ankara will wait until it has raised most of its US$5.5bn Eurobond funding needs for 2006 before turning to an exchange. That would mean late second quarter 2006 timing at the earliest.

Investor acceptance of such a move will depend on the attractiveness of the new bond(s) on offer, but given the typical take-up at liability management operations of 30%–40%, an exchange totalling US$2.5bn–$3bn seems reasonable, according to one EM syndication manager.

A buyback would obviously mean tapping into FX reserves. The strong lira has helped propel Turkey's reserves to just under US$60bn. But in contrast to Brazil, which runs a large current account surplus, Turkey posted a huge deficit last year at US$22.8bn. While this is comfortably financed – in part through FDI – at the moment, Commerzbank's Kronsten suspects the Treasury would like to maintain reserves at six months' import cover, which is roughly where they are at present.

Akcay's comment: "We do not contemplate pure buybacks at the moment."

On the often discussed – at least by bankers – topic of Islamic financing, Finance Minister Kemal Unakitan, speaking at last November's International Islamic Finance Forum (IIFF), touched on the topic. He said that Turkey was open to investors from all over the world to help finance the current account imbalance, and banks that offered Islamic services could increase their current 3%-4% market share.

"Investors in the Gulf region represent a market niche which has not been tapped so far," said Akcay. "In order to attract these investors, in addition to our conventional bond issues we have developed an instrument called 'rent certificates'. In order to issue such instruments, a draft law has been prepared and its enactment process is underway."

But JPMorgan Turkey economist Yarkin Cebeci is sceptical about the prospects of such a deal. He points out that such a move would be bound to create controversy given the country's secular constitution, while the funding is hardly essential in view of Turkey's much-improved fiscal position on the back of prudent policies and the pick-up in privatisation receipts.

Brazil's real-denominated global bond also looks unlikely to be replicated anytime soon by Ankara. A London-based EM origination manager noted that the Turkish Treasury typically likes to build a curve, so one-off deals are unlikely. The lack of withholding tax revenues from Global lira issues is another consideration.

Certainly the Treasury seems yet to be convinced. Akcay acknowledges that Global lira bond issuance is an option for Turkey, especially for maturity extension and cost savings in the domestic market. However, he added:" It is an instrument in an infant stage, which has to be explored thoroughly before launching. There is some uncertainty whether local currency Eurobond market represents a new channel for funding."

Aside from the sovereign, straight Eurobond issues have been all too rare in Turkey. The loan market continues to dominate corporate funding thanks to the large group of local banks that can fund companies at very low rates. Top-tier, one-year loans are being priced around 30bp over Libor (at the margin) and 60bp for three-year paper. And even though Turkish Eurobond spreads have tightened markedly, they are still much higher than the differential for syndicated loans.

The main justification for Turkish credits to tap the Eurobond market would be for extended duration, but further out along the curve it is cheaper for Turkish firms to issue through securitisation of future flows than through straight Eurobonds. Turkey saw US$5.5bn of offshore securitisations in 2005, all future-flow ABS and DPRs. A similar, or higher total is expected this year. (See separate article on developments in the securitisation market.)

Finansbank launched Turkey's first non-sovereign vanilla Eurobond since June 2004 and the first by a Turkish bank, with US$110m five and seven-year issues this March through sole bookrunner Morgan Stanley, while airport operator TAV meanwhile has mandated HSBC, Bear Stearns and HVB for a debut Eurobond likely to be priced in May.

A few banks are also believed to be exploring subordinated bond issues. Here the talk is of tier II 10 non-call five-year transactions, either through a public issue or private placements to raise the capital base and so accommodate growth as car and consumer loans accelerate on the back of falling local interest rates.