From Attempted Coup—to Economic Recovery
While Turkey’s overall macro picture still warrants some caution in the long term, we see reasons for getting more constructive as we enter the second half of 2017. After the failed coup attempt last summer, the economy slowed down significantly, but the government responded with extensive stimulus measures that led to a cyclical recovery that began late last year. The measures included temporary tax cuts and large loan guarantee programs—both of which stimulated domestic demand.
Also, late last year, the Central Bank of Turkey reversed its policy of easing monetary conditions and tightened liquidity conditions. That move led to an increase of about 400 basis points in short-term interest rates, which in turn helped to stabilize the Turkish lira. After peaking at 3.87 liras to the U.S. dollar in January, the Turkish lira has been strengthening and now appears to show signs of leveling off (Exhibit 1).
The Turkish economy is not without its weakness: A large external debt burden, ongoing current-account deficits, rapid credit growth, high inflation, and political uncertainty—all remain key challenges. But Turkey still has safety buffers, such as fiscal latitude, which the government is now effectively using.
The Implications for Turkish Fixed Income
Turkey’s economic resilience surprised market participants this week, when gross-domestic-product (GDP) growth in the first quarter registered a solid 5%. We think this growth rate bodes well for corporate issuers in the country, which we believe are likely to report solid earnings in the coming quarters. The government’s stimulus measures also favor certain sectors in the economy, creating the potential for investment opportunities. For example, tax reductions on white goods (i.e., certain electrical household appliances) and furniture manufacturers favor companies in these sectors. Meanwhile, the government’s loan guarantees help banks by reducing part of their credit risk and shifting it to the state.
The current recovery in asset prices is reflected in sovereign and corporate credit spreads. On the sovereign side, Turkish credit default swaps (CDS) have been recovering since the beginning of the year and are now trading at approximately 185 basis points, which is roughly flat to South Africa and 30 basis points above Russia.1
Turkey is still underrepresented in investors’ emerging market fixed-income portfolios. Yet with ongoing inflows into the asset class and cyclical stabilization, we believe Turkey is catching up, with its credit spreads likely to tighten even more (Exhibit 2). In our view, the best way to capitalize on this trend is by investing selectively in Turkish corporate and banking bonds, where investors can seek to benefit from the current potential for an extra 100-200 basis points in spreads.
The Turkish Bond Universe: Where We Are Looking
When investing in Turkish corporate bonds, investors have a wide selection of sectors including large conglomerates, industrials, food and beverage manufacturers, and energy and transportation companies. The banking sector includes state-owned and privately-owned banks, some of which are part of large international financial groups.
We find the credit fundamentals of Turkish corporate and banking bonds to be solid, in part thanks to a vigilant banking regulator who has aimed to curb the risks of financial institutions through capital requirements, strict controls on banks’ exposure to foreign exchange, and the rapid implementation of Basel III reforms.
Management teams of Turkish companies are generally experienced in having successfully navigated the ups and downs of the Turkish economy and currency volatility. Their conservative approach is reflected in the average leverage2 on Turkish company balance sheets, which stands at only 2.6. This rate is lower than in most emerging markets, and is less than half the leverage of the typical high-yield bond issuer in the United States (Exhibit 3).
This low leverage can translate into the potential for investment opportunities with appealing risk/return characteristics. In fact, Turkish corporates currently offer one of the most attractive spreads per unit of leverage in emerging markets. This basically means that investors can seek to benefit from the current potential of higher spreads without necessarily having to incur higher credit risk. Another interesting feature of Turkish corporate and bank bonds is that, for the most part, they have shorter duration: Maturities of longer than five years are not as prevalent. The upshot for fixed-income investors is the potential to benefit from lower interest rate risk.
Increasing Our Fixed-Income Exposure in Turkey
Recent meetings we’ve had with officials and management teams of Turkish banks and other corporations reinforce our more constructive view of the country as we enter the second half of 2017. Management teams continue to run companies in a conservative way: Most companies are not pursuing big investments or acquisitions that could jeopardize the health of their balance sheets.
Turkish exporters have been benefiting from a weaker local currency, with operating margins expanding in 2017. On the banking side, non-performing loans remain at low levels and capital ratios are strong for the leading banks. Banks’ exposure to foreign exchange, a concern for some investors, seems in our view to be manageable, as loans are mostly directed to exporters and companies with international operations.
As a result, we have been gradually adding to our fixed-income exposure to Turkey on a selective basis. In our view, the primary bond market is an attractive option in periods of low market volatility because new bond issues—particularly those with lower credit ratings—usually provide some premium over their existing bonds. A scenario of high volatility or a market dislocation may also provide the opportunity to enter the secondary bond market. In such a scenario, we think investors could find attractive opportunities in Turkish credit, particularly among:
- Exporters or companies with international operations
- Large conglomerates with diversified revenue streams
- Domestic companies that have revenues linked to, or denominated in, hard currency (i.e., the dollar)
- Large banks, which are systemically important institutions
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1Russia and South Africa are among the closest comparisons for Turkey in the Eastern European and African emerging markets.
2Defined as total corporate debt divided by EBITDA (earnings before interest, taxes, depreciation and amortization).
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