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Local bond market showing signs of much needed maturity

By Gerald Hayes
08 Jan 2014

Turkey’s local bond market impressed last summer, coping with the volatility caused by US Federal Reserve tapering fears and civil unrest. However, it will have to diversify if it is to help the government reduce its worryingly high current account deficit. Philip Moore reports.

Although it is famously difficult to get economists to agree on anything, there is a general agreement among those that follow Turkey that the size and obstinacy of its current account deficit is the economy’s main weakness. That explains why two strategic goals are being earmarked as essential if Turkey is to achieve its ambitious goal of becoming the third largest economy in Europe by 2023.

The first of these is to increase Turkey’s modest savings rate, which is understandably low by international standards. Turkish consumers, after all, don’t need to be too old to remember when domestic inflation topped 100%, which gave them few — if any — incentives to save. Although triple and even double-digit inflation is now a thing of the past, Turkey remains a nation of spenders rather than savers. 

A second key objective if Turkey is to chip away at its current account deficit is to reduce the country’s annual bill for imported energy, which today stands at about $55bn. According to a recent presentation delivered by Turkey’s Ministry of Finance, between now and 2030, its energy demand will grow by 146%. That means Turkey will be second only to China in terms of energy demand growth over the next decade and a half. 

İzlem Erdem, manager of the economic research division at Işbank in Istanbul, says that this makes it all the more important that Turkey channels investment into developing alternative energy sources. “Oil will continue to be our main energy source and the biggest contributor to our current account deficit,” she says. “But 5% or 10% of this could eventually be replaced by alternatives such as renewables.”

The twin goals of bolstering the domestic savings rate and encouraging more investment in energy projects would both be supported by the growth of a more diversified domestic bond market. Already, say local bankers, Turkey has successfully built a highly deep and liquid domestic government bond market which continued to attract support from international as well as local investors during the tumultuous summer of 2013. 

“The combination of civil unrest and Fed tapering led to fears that there would be a big decline in the participation of foreign investors in the domestic government bond market, which didn’t happen,” says Selim Çakir, chief economist at TEB BNP Paribas in Istanbul. “We saw a slowdown in new inflows, but investors who were already exposed to the Turkish market maintained their exposure. I believe that reflects a belief on the part of international investors that the fundamentals of the Turkish economy are strong enough to withstand external shocks.”

PD support

At ING in Istanbul, senior vice-president Murat Yardimci says that liquidity in the domestic bond market has been supported by the robust primary dealership system, which has encouraged increased participation by international investors across the yield curve. “Ownership of local debt by overseas investors has increased over the last two years and now stands at about 26%,” he says. “This means that around $60bn of the debt stock is now owned by foreign investors. While foreign investors used to focus on the short end of the curve, the upgrade to investment grade has attracted a lot of real money investors at the longer end. I’d say at least 50% of the $60bn owned by foreign investors is in 10 year bonds.”

Sanem Tatlidil, head of international business and product development at Garanti in Istanbul says that foreign participation in the domestic government bond market will expand further still if and when S&P joins Moody’s and upgrades Turkey to investment grade.

Bankers say that the growth of the government bond market has laid the foundations for the development of an increasingly liquid sector for non-government issuers, most conspicuously for bank borrowers. “The state and the government have done a fantastic job in building up the domestic capital markets over the last 12-13 years,” says Olcay Yagci, managing director at Bank of America Merrill Lynch in London. “It began by cleaning up the banking system. Then it brought in regulations to support institutional investors in the domestic government bond market. The next step, which is already in play, is to open up the domestic market still further to non-sovereign issuers.”

This process has gathered momentum over the last two to three years. Müge Ekşi, head of capital markets advisory at Yapı Kredi Yatırım in Istanbul, says that the key milestone for the market was passed in 2010, when the Banking Regulation and Supervision Agency (BRSA) allowed banks to issue in the local market. 

Double-edged sword

This has been something of a double-edged sword, because while it has added liquidity to the local market, it has also meant that issuers from outside the financial sector have remained largely crowded out. “Starting from 2012, we have seen issuance from non-bank FIs, such as factoring, leasing and consumer and car loan companies, as well as corporates,” says Ekşi. “But while we observe strong growth in the non-bank segment, the market is still dominated by local banks.”

Garanti’s Tatlidil agrees that the market remains very bank-heavy, but says she is encouraged by signs of more diversification of supply. “Of year-to-date issuance of about TL3bn, 87% has been accounted for by banks,” she says. “But we are seeing more industrial companies coming to the market. Since 2006, Garanti has managed 64 corporate debt offerings out of a total of 215 corporate bonds issues in the Turkish capital market.”

Aside from remaining heavily skewed towards bank issuers, the relative immaturity of the domestic non-sovereign market is reflected in its concentration at the short end of the yield curve and in its modest liquidity. “Excluding a few benchmark bonds, the market is quite illiquid,” says Volkan Kızıltan, assistant general manager in charge of brokerage and execution services at Yapı Kredi Yatırım in Istanbul. “Investors generally treat bonds as hold-to-maturity investments. That is why tenors are quite short, generally less than two years.” 

For tenors of more than one year, adds Kızıltan, issuance is mostly in floating rate note (FRN) format, with investors still uneasy about taking exposure to fixed rate bonds given the volatility in the market. “Investors tend to compare bond returns with those on bank deposits, so banks need to take account of deposit rates when pricing new issues,” says Kızıltan.

The relative illiquidity of the market, says Kızıltan, is one reason why international participation in the non-sovereign market, which was worth just under TL35bn as of October 2013, has been modest, with investor demand led by domestic asset management companies, pension funds and banks. 

Retail investors are also an increasingly important source of demand for local currency non-sovereign bonds, holding about TL11.8bn, or 34%, of the market. Ekşi puts the total share of local investors at about 95% of the market. 

Pension fund push

One impetus for the further growth of the domestic bond market in Turkey has been the introduction of a range of incentives designed to accelerate the growth of the country’s embryonic pension fund industry. The most significant of these has been the passage of a new law under the terms of which the government makes a 25% contribution to individuals’ private pension accounts. 

According to Fitch Ratings, in the first eight months of 2013, assets under management in the Turkish fund management industry rose by 9.3% to TL55.2bn. Growth was led by expansion in the pension fund sector, which accounts for 43% of the industry’s total assets, which posted a 16.7% increase. Pension fund reform, according to Fitch, led to more than 4m new investors moving into the pension fund market, lifting the total number of pension fund investors by more than 50%, to 12.3m.

“We believe the sector growth will continue over the next several years,” Fitch adds, “given the young average age of Turkey’s population and the level of state contribution. We expect that the number of pension fund managers will increase from the current 17.”

Inevitably, much of this expansion will encourage a rise in equity-based funds. But bankers also expect it to lead to an increase in investment in the fixed income market. This is turn should encourage more issuers from outside the financial services sector to look at the potential of the bond market as an alternative to bank lending. “I believe we’ll see many more second tier companies in sectors such as construction coming to the domestic bond market,” says Yagci at BAML. “Although issuers will be subject to refinancing risk because it is a short-dated market, it will be an attractive alternative for companies in need of short-term funding which don’t want to take on the full disclosure of a Eurobond transaction. Issuing in the domestic market also means they can avoid delving into risk management and increased exposure to FX and rates. It is a naturally hedged transaction for most of them.”

Views are mixed on how much of a role the domestic bond market will play in funding Turkey’s immense infrastructure investment requirement. With most of the projects still at the greenfield stage, if the bond market does play a significant role, it is unlikely do so for at least the next three or four years.

Bankers do, however, expect to see growth in the domestic market accompanied by increasing diversification. One potential source of new issuance, say Istanbul-based bankers, is in the asset-backed market. Another is the market for Islamic bonds. “The balance sheets of Turkey’s participation banks are growing at an annual rate of around 25%-30%, and as these banks will need to find alternative sources of funding to deposits, there is definitely scope for growth in the sukuk market,” says Yagci at BAML. “We have already seen the first domestic sukuk transactions for Bank Asya, and I expect to see more issuers come to the market.” 

By Gerald Hayes
08 Jan 2014