Earlier this month asset manager Zyfin launched the first UCITS-compliant exchange-traded fund tracking the Turkish sovereign bond market, increasing the range of investment opportunities available to European ETF investors. With a weighted average return at around 9.5% the fund will appeal to long-term investors searching for higher yields in growing emerging markets. However, higher yields mean increased risks and investments within Turkey contain significant currency, inflationary and idiosyncratic risks requiring closer examination to determine whether it is suitable to hold in an investment portfolio.
Sanjay Sachdev, Executive Chairman of asset manager ZyFin, said: “Investors should not ignore Turkey. Its 80 million population, alignment with the EU and strategic advantage as a bridge between Europe and the East bodes well for the long-term development of its economy.”
While Turkey is officially defined as an emerging market economy by the International Monetary Fund, it is commonly known by economists and political scientists as one of the world’s newly industrialised countries, boasting the 18th largest nominal GDP and 17th largest GDP by purchasing power parity. The economy is well diversified across sectors that include agricultural products, textiles, motor vehicles, ships and other transportation equipment, construction materials, consumer electronics and home appliances, defence, steel-iron production, science and technology, and tourism. This diversification has provided the economy with a degree of resilience from external shocks in recent years.
According to the OECD, GDP growth is projected to be around 4% per annum for the remainder of the year and in 2017. This has been aided by the government increasing the minimum wage, which has increased disposable incomes and boosted private consumption, though some analysts note that the associated increases in labour costs could dampen growth over the medium term, despite subsidies in the first year to alleviate them.
This, and a depreciating currency, has contributed to inflation in Turkey being higher when compared to similar countries at this stage of development. But, there are signs of improvement. Year-on-year inflation in Turkey has been reducing – reaching a three-year low of 6.5% in April, according to the Turkish Statistics Institute. More importantly, the core rate of inflation (which excludes volatile items such as food, gold and energy items) fell from 9.4% in April to 8.7% in May, suggesting more price stability over the long term.
Turkey’s balance sheet
Investigating the government’s balance sheet, ratings agency Moody’s found the ability of the government to finance its outstanding debt pile is supported by a relatively low share of foreign currency-denominated debt, shielding the government’s balance sheet from further depreciation of the Turkish lira against the US dollar. With average debt maturity at over six years for locally-denominated debt and almost 10 years for foreign currency-denominations, the term structure of the outstanding debt is supportive of a smooth running market.
However, the Turkish economy does have significant external refinancing requirements estimated at over 27% of GDP. The pressure point is the banking system, which has borrowed over $100bn from foreign investors since 2008. Furthermore, persistent current account deficits and decreasing foreign exchange reserves are adding further pressures. Turkey is one of the world’s largest importers of oil and a sharp increase in energy prices may precipitate a balance of payments crisis. These factors may leave Turkey exposed to unfavourable shifts in investor confidence in the future, potentially causing strain in the sovereign bond market as well. Additionally, if the US increases the pace of interest rate normalisation, it could put pressure on the rate at which the government is forced to re-finance.
Turkey’s credit rating for foreign denominated debt is currently on the threshold between investment grade and junk status, according to the three major ratings agencies. Standard & Poor’s rating stands at BB+ (one notch below investment grade) with a stable outlook, while Moody’s and Fitch’s credit rating for the country are Baa3 and BBB-, respectively (each is one notch above junk) with a negative outlook. This positioning leaves Turkish government bonds open to significant price movements in the event of relocation into or out of each bracket: historically, investment fund restrictions, and the psychological impact of shifting between investment grade and junk status, has resulted in significant changes to investor demand for bonds that are subject to a change in credit bracket.
Political risk factors
Political risk factors play a significant role in Turkey-based investments with the civil war in neighbouring Syria continuing to increase societal tensions within the country. An estimated 2.9 million refugees are currently in Turkey, according to a European Commission report issued in May 2016.
Current party political volatility has also raised scrutiny from investors. In the past year, Turkey has held two general elections, re-engaged conflict with the minority Kurdish rebels, and suffered political infighting which led to the forced resignation of Prime Minister Ahmet Davutoglu by President Recep Erdogan. Davutoglu’s resignation was seen as an indicator that Ergodan is shifting the country towards an increasingly authoritarian regime. It prompted the worst weekly fall in the Turkish lira for 14-months. Analysts see Erdogan’s consolidation of power as a serious threat to freedom of speech, women’s rights, the Kurdish peace process, and the rule of law, which are all significant contributors to business confidence in the country.
Many also fear that an entrenched presidential system will bring about federalism in the country, leading to a dissolving of Turkey’s fragile unitary structure and prompting calls for independence from within the federalist regions.
Despite its ongoing political problems, the acute crisis of leadership that developed in May seems to have abated for now. Davutoglu was replaced by Binali Yildirim, a respected technocrat who is well known for his work in boosting Turkey’s infrastructure. Furthermore, the confirmation that Deputy Prime Minister Mehmet Simsek, a key member of Turkey’s economic management team, would keep his position, provided a degree of continuity and reassurance to investors – the lira rebounded positively on the announcement.
Commenting on the riskiness of the ETF’s underlying holdings, Sanjay Sachdev, Executive Chairman of ZyFin, said: “Investors understand that there are inherent investment risks with Turkey – particularly currency risk, inflation risk and geopolitical instability. But those risks are fairly rewarded with return in the form of a yield of circa 10%.
“Investors should not ignore Turkey. Its 80 million population, alignment with the EU and strategic advantage as a bridge between Europe and the East bodes well for the long-term development of its economy.”
Turkey’s economic robustness
Supporting this argument, the diversity and relative robustness of the economy, improving inflation, as well as the favourable structure of the government’s balance sheet, all serve as positive reinforcements for investment in the country. These factors not only favour strong performance in a Turkish sovereign bond ETF but also support the case for investing in ETFs tracking Turkish equities. Investors may gain such exposure through the following UCITS-compliant funds:
The iShares MSCI Turkey UCITS ETF (IDTK LN) provides direct exposure to a broad range of companies in Turkey through tracking the MSCI Turkey Index. As of 13 June 2016 the major sector exposures are financials (46.5%), consumer staples (15.2%), industrials (11.1%) and telecommunications (8.3%). There are 24 holdings in the fund of which the largest constituents are Turkiye Garanti Bankasi (11.9%), Akbank (11.9%) and Bim Birlesik Magazalar (8.4%). The fund has a total expense ratio (TER) of 0.74% and is up 9.9% year-to-date (YTD).
Deutsche Asset Management’s MSCI Turkey Index UCITS ETF (XDTK LN) also tracks the MSCI Turkey Index, maintaining similar sector and security holdings as the iShares ETF. It has a TER of 0.65% and is up 11.2% YTD.
The Lyxor Turkey (DJ Turkey Titans 20) UCITS ETF (TURU LN) tracks the performance of the Dow Jones Turkey Titans 20 Index, a reference for 20 Turkish-listed equities with the most significant capitalization and liquidity. Constituents are capped at 10%. As of 13 June 2016 the major sector exposures are financials (47.3%), industrials (15.0%), and consumer staples (9.6%). The largest constituents are Akbank (10.1%), Turkiye Garanti Bankasi (10.0%), Bim Birlesik Magazalar (9.6%), Haci Omer Sabanci (8.9%) and KOC (8.0%). The TER is 0.65% and the fund is up 11.0% YTD.
Turkey also plays a minor role (1.5% – 2.3%) in emerging market ETFs from providers such as iShares, Source, State Street Global Advisors and WisdomTree.