Turkish corporate bonds – A fundamental opportunity

The macro backdrop in Turkey has been challenging with elevated inflation, balance of payments concerns and presidential elections, which has resulted in significant asset volatility at both the sovereign and corporate levels in the country.  However, we believe this provides a compelling opportunity to generate very attractive yields by investing in high-quality companies capable of operating in such an environment.

After a closely contested race, President Recep Tayyip Erdogan won Turkey’s presidential election in May, defeating opposition leader Kemal Kilicdaroglu with 52.1% of the vote.     The result stretches Mr Erdogan’s rule into a third decade but the tight margin of victory indicates a divided country.

Turkey is uniquely positioned geographically between East and West.  Its size, population and strategically important location give Turkey major influence in the region.  At the same time, it is faced with economic and social challenges including a large current account deficit, a depreciating currency and high inflation, notwithstanding the aftermath of February’s devastating earthquake that shook southern Turkey and Syria.

Inflation was the hot topic globally in 2022 as geopolitical tensions triggered higher energy costs and supply-side disruptions raised consumer prices.  Inflation rates across the OECD hit a 34-year high of 10.7% in October compared to a year earlier.  Turkey topped a list of 38 member countries with inflation peaking at 85.5%.  Despite this, its government prioritised the support of economic growth and employment, cutting interest rates when an orthodox monetary policy would have expected it to raise them. 

Turkey faces currency woes following President Erdogan’s re-election

Deeply negative real interest rates (as inflation is higher than rates) have made it attractive to borrow and spend, rather than save.  This supported strong real GDP growth of 11.4% in 2021 and 5.5% in 2022.  However, given the high rate of inflation, the policy had ramifications and shook investor confidence.  

The Turkish lira depreciated by 40.6% in 2022 and there were increased concerns about a balance of payments crisis on the back of a widening current account deficit and depletion of sovereign foreign currency reserves.  Partially offsetting these worries were timely capital inflows from neighbours in the Middle East and Russia, reflecting an improvement in relations between the countries and adding a political element to the economic issues.

With interest rates as a policy instrument for inflation off the table, the government turned to other indirect measures targeted at banks and corporates to influence the economy and shore up its balance sheet.  In the financial sector, regulatory changes were introduced, including additional reserve requirements and limitations on Turkish lira loans to companies with high hard-currency cash holdings.  

Such measures were designed to curb loan growth and the spending boom that had been partly responsible for the inflation effect.  Meanwhile, companies saw regulation tighten on export revenue conversion to Turkish lira as the central bank looked to support the currency and bolster foreign currency reserves.

Sovereign volatility has a knock-on impact on Turkish corporate valuations

This challenging backdrop resulted in significant volatility for Turkey’s sovereign bond yields and credit default swaps during the year.  This volatility had a direct impact on corporate bond yields, which closely track sovereign yields, despite many companies being in better shape.  At the time of writing both sovereign and blue-chip company US dollar-denominated bonds yield around 8-9% in USD.

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