The Turkish lira’s plunge this year has wiped out a third of the value of foreign investors’ holdings of lira bonds, but data shows there have not yet been net foreign portfolio sales.
That may reflect inertia or a lack of liquidity.
On paper, Turkey’s $120 billion sovereign domestic bond market has been a disaster for overseas investors this year. The lira has lost 28 per cent year to date — its sixth straight year in the red — while the capital value of the bonds has dropped more than 20 per cent.
Losses have accelerated in recent weeks as markets balked at President Tayyip Erdogan’s policy of keeping interest rates low even with inflation at a 14-year high. His decision to put his son-in-law in charge of the economy while ousting familiar and experienced faces after assuming additional powers has also unnerved some investors.
Emergency interest rate hikes have pushed yields to some of the highest in the emerging markets universe but real rates are around 2 per cent. Turkey is the second-worst performing market in the GBI EM index of local currency debt behind Argentina.
Yet, foreign investor money has proven stickier than many expected. The big question now is whether these huge paper losses will be realised at some point if there is no resolution to the crisis, leading to some capitulation that could intensify the financial squeeze.
“The perception of foreign selling of Turkey government bonds ... is not happening,” said Morgan Stanley strategist Min Dai.
Data from the Institute of International Finance tracking weekly foreign portfolio flows showed that Turkish local government debt had suffered outflows in the two weeks ending July 27, but was still $75 million up on the year.
Central bank statistics confirm the trend, showing the ratio of foreign holdings of government debt stood at just under 20 per cent at the end of last month — largely unchanged from 22 per cent in late February.
Foreign investors have stayed put for a number of reasons, said Min.
Liquidity has deteriorated significantly, with daily volatility of 50-70 basis points (bps), he wrote in a note to clients. And while a slight underweight compared to JPMorgan’s GBI EM benchmark index offered real money investors a chance to outperform the benchmark, they would find it difficult to cut their exposure dramatically given the 18-20 per cent yield.
The monthly index rebalancing, which did not reflect the drop in the underlying securities, also helped investors secure that underweight without having to sell, Min added.
Recent dramatic falls may have been another anchor, said Paul McNamara, investment director at asset manager GAM.
“There is always this kind of sunk cost feeling — the money is already lost,” said McNamara.
Some funds have used the recent market turmoil to increase their exposure. Asset manager Aberdeen Standard Investments said in early June it had upped its exposure to domestic Turkish debt following a bigger-than-expected interest rate hike by the central bank.
But that stickiness may not persist. Apart from holding around $20 billion of government debt, foreign investors also own around $33 billion of Turkish stocks, providing some much needed finance for the country, which runs a gaping current account deficit.
“Portfolio investors need to believe the story in terms of the policy mix — real interest rates need to stay sufficiently high to provide enough carry for FX risk,” said Tim Ash, strategist at BlueBay Asset Management.
“That’s a dangerous mix if the $50 billion plus portfolio funds begin to exit — suddenly your external financing gap gets that much bigger,” he said, adding that such an exit could also hasten further local dollarisation.
Morgan Stanley’s Min said there were reasons to be bearish and that investors should base their views on fundamentals rather than expectations of how long fellow investors may hold onto the securities.
“We are concerned about the prospect of Turkish government bonds’ future return,” he wrote, adding that while slowing growth was expected to help rebalance the economy, this may not happen to the extent investors are hoping for.
Rising inflation in combination with a central bank staying its hand on rates makes a difficult proposition for investors going forward, said Phoenix Kalen, strategist at Societe Generale.
“If real yields plunged towards zero, then the investment thesis doesn’t make sense anymore for Turkey,” she said.