Learning to gaze inwards

Turkey’s local currency debt markets only started to develop about five years ago before issuance started to take off in 2012. As with many new markets it has faced considerable challenges in its early years, not least persistent inflation and high rates, but bankers hope a maturing pension fund industry will increase interest in the sector.

From a near standing start five years ago, Turkey’s local bond market has grown rapidly in recent years. Yet like any new market it has faced challenges, particularly from the uptick in FX volatility and uncertainty about the future path of rates, both in Turkey itself and in the US.

The market has seen increased activity since the government introduced new legislation that lowered the tax rates incurred and easing the registration procedure. Growth has been impressive in percentage terms but having started from such a low level, activity remains modest in absolute terms, as well as patchy. Meanwhile, macroeconomic conditions remain challenging.

“The pace of growth in 2015 is likely to be impaired by the TL depreciation and reversal of liquidity flows out of EM and back to mature markets,” said Tommaso Ponsele, director of CEEMEA DCM at Citigroup.

Local debt markets tend to be driven by the rise and fall of inflation, interest rates and the relative strength of local currencies. The lira bond market is no exception, its fortunes traditionally being undermined by the high levels of inflation in Turkey, which ensure high interest rates on lira debt. This has encouraged the larger corporates, which enjoy access to foreign currency debt markets, thereby locking in lower interest rates.

While interest rates remain relatively high in Turkey, compared with what is seen in the euro and dollar markets, interest in lira-denominated debt started to take off around 2012, when Turkish rates started to fall, meaning greater convergence with US rates.

Corporates that had lira-denominated revenues preferred the natural hedge of having their liabilities in the same currency, and as the cost fell an increasing number started to look to the local markets for capital – a trend also evident in other emerging markets such as Poland and Israel, which have been through similar stages of development in recent years.

For a while, the rates outlook for 2015 looked favourable for the market to gain even more ground.

“The lower oil price had been expected to have a strong impact on the balance of payments in Turkey, reducing the current account deficit by up to US$20bn,” said Danny Tenengauzer, head of EM and global FX strategy at RBC.

As it turned out, the benefit from cheaper oil has been less than expected – more like US$5bn–$10bn – so “Turkey will have to keep rates higher to continue to attract flows”, he said. This has undermined the business case for raising capital in lira.

Yet while the path of rate decline in Turkey is hard to chart, rates do seem set to fall in the longer term, and this is good news for the long-term prospects for lira debt markets.

“If lira rates continue to fall we will see more and more issuers come to the lira bond market,” said Selim Kervanci, head of capital financing for MENA and Turkey at HSBC, as corporates seek to eliminate the FX mismatch between their assets and liabilities.

How fast the market develops will therefore be determined largely by how successful the Central Bank of Turkey is in fighting inflation and attracting investment to service its current account deficit.

“I think we will see around 6.5% inflation some time this year as long as we do not see aggressive rates cuts,” said Tenengauzer. With the lending rate at 10.75% and inflation around 7.60%, the real rate is positive, leaving room for gradual rates cuts, he added.

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In 2014, the majority of lira-denominated bond issuance came from banks. Of total issuance of TL31bn for the year, TL26bn came from banks, while much of the remainder came from non-bank financial institutions. This year again, banks have led the way, with DenizBank, Fibabanka, Garanti, Akbank and Aktif Yatirim Bankasi all in the market in 2015, as well as Dutch bank ING.

The case for non-financial corporates to issue lira bonds remains a tough one to make. Such institutions maintain strong relationships with their banks, which, unlike their European counterparts, remain liquid and unencumbered by regulatory capital constraints. Turkish banks therefore enjoy a greater capacity to provide loans to their clients that in most cases fulfil their capital requirements, and at favourable rates.

That has meant Turkish corporates have little need to look elsewhere for capital, with the additional disclosure and paperwork that would entail. And even those that have made use of the debt capital markets have generally been quiet in 2015 because they issued in recent years and still have the capital they need available – a trend that has also been evident in the Eurobond market (see box).

“One big challenge for local currency debt in Turkey is tenor. Most issuance is very short term, between six months and one year, or very occasionally three years”

Neither does the lira bond market, in its current, embryonic state, offer the kind of flexibility that might tempt them to diversify their funding sources. “One big challenge for local currency debt in Turkey is tenor,” said Kervanci. “Most issuance is very short term, between six months and one year, or very occasionally three years.”

This is slowly starting to change and in December YDA Insaat Sanayi ve Ticaret, the construction subsidiary of YDA Group, issued a three-year TL200m (US$74m) lira bond offering, a rarity for a mid-sized company in its sector. But this only highlights the lack of duration available from most issues.

This has been exacerbated by volatility in the currency markets.

“The Turkish lira interest rate curve has risen very noticeably as the currency depreciated,” said Ponsele. “That has made this market a relatively expensive place for many of the corporate issuers to source funding from – particularly in a year where growth is likely to be relatively slow and funding needs limited.”

Part of the problem is the absence of an established, mature institutional investor base. Recent years have seen the gradual emergence of a pension funds industry, and a culture of saving in pension funds.

Until now, however, the institutional investors that are active in Turkey have tended to prefer equities to fixed-income investments because Turkish equities have proved far more resilient to the currency movements and variations in inflation, said Ponsele. But their long-dated liabilities mean pension funds are a natural buyer of longer-dated paper and as the pension fund sector matures and its assets under management grow, demand for longer-dated paper should increase.

Turkey’s private pension industry expanded at a compound annual growth rate of around 33% in terms of AuM between 2009 to 2014, according to HSBC, with the entire pension market reaching nearly TL38bn in AuM, including a state contribution of TL3bn. Yet the industry still has less than 2% of Turkish GDP in AuM – well below OECD levels.

The Turkish government has been keen to change this and promote the emergence of a healthy pension fund sector. It has created incentives to Turks to invest in pension funds by contributing an extra 25% for every penny saved in the pension system, reducing fee caps and introducing a new tax regime for foundations and trust funds. There has also been talk of auto-enrolment into the private pension system and directing employee severance payments into indemnity funds, said Kervanci.

TSB Vision 2023, the report prepared by the Insurance Association of Turkey, projects the pension fund industry will have assets under management of TL408bn by 2023 based on favourable GDP and savings rate projections, and as a result of increased government support.

If pensions develop at anything close to that rate it should make a considerable difference to the lira bond market.

“We will see maturities extend on local currency issuance as the pension fund sector grows. I expect to see corporate and FIG issuance at three to five years within the next few years,” said Kervanci.

The hope is that increasing liquidity in the lira debt markets will create a virtuous circle.

“Investors like mutual funds need a certain level of liquidity before they will be comfortable investing, so they know they will be able to sell their positions. The more liquid lira debt becomes the more investors will buy, and that should bring more issuers to market,” said Kervanci.

But finding a degree of stability in the FX market is another prerequisite. Coupled with a larger pool of domestic savings, this should ensure “demand conditions aren’t driven as much by foreign investor views on the currency”, said Ponsele.

Hakkı Gedik, a partner at Allen & Overy in Istanbul, said he expected the domestic bond market to gain momentum again after the general elections.

“The general expectation is that Turkey will continue to have a strong government after the elections, which is expected to prioritise its efforts towards stabilising the currency and dealing with economic slowdown and inflation,” he said.

If the lira market develops as many hope, it should have a positive impact on the economy as a whole, but it will be felt most in the longer term, said Kervanci.

“Turkey has huge growth potential but this needs financing and Basel III is making it more costly for banks to finance things like infrastructure projects. So ultimately I can see more things like infrastructure projects being financed in the capital markets, though this will take time,” he said.

“The development of an active domestic capital market for fixed-income product would provide a valuable shock absorbing mechanism for the Turkish economy,” added Ponsele. “It would also help bring a better balance in the corporate balance sheets, particularly in the MME/SME sector.

“Several entities in this section of the economy currently run an open FX position in order to fund themselves in a cost-effective way, which can prove challenging in periods of currency weakness. South Africa, Israel, Russia, Poland – among several others – have all seen the benefit of a well-functioning and liquid domestic bond market.”

“It will also contribute to a more diversified financial system by spreading the credit risk between the investors, which are mainly held by banks in domestic lending and decrease the banks’ risks of maturity mismatch between their liquid short-term assets and long-term liabilities,” added Gedik.