Investors Hedge Against Turkish Price Risk: Inflation Bonds

Turkish bond investors are paying the highest price ever for protection against inflation, casting doubt on the central bank’s forecast that price increases will slow even as economic growth rivals that of China.

The gap between yields on two-year inflation-linked bonds and standard discount notes, known as the breakeven rate, is close to a two-year high at 7.4 percentage points. Turkey’s inflation-linked bonds outperformed all 18 countries tracked by Bank of America Corp.’s Merrill Lynch & Co. for three years, as investors bet that Turkey’s boom will translate into more missed inflation goals.

Money is pouring into Europe’s fastest-growing economy. Spain’s Banco Bilbao Vizcaya Agentaria SA agreed on a $5.8 billion bank acquisition this month, and investors pushed stocks and bonds to record highs. The inflows also boosted the lira, making Turkey’s exports less competitive, and any move by Governor Durmus Yilmaz to bring inflation in line with his target by raising interest rates may risk further appreciation.

The inflation-linked bonds have surged because “the central bank is being very dovish and inflation is already high,” said Angus Halkett, a fixed-income analyst in London for Deutsche Bank AG, Germany’s biggest bank. Growth is “by far the strongest in the region, and that’s tending to drive a rise in expectations for inflation.”

Turkey’s $700 billion economy grew more than 10 percent in the first half. Consumer loans have risen a weekly average of 0.8 percent since January.

‘Behind The Curve’

The central bank has kept its benchmark rate at a record low of 7 percent for a year. Yilmaz says he can delay increases another year and still bring inflation down from 8.6 percent last month. He points to a core rate, excluding food and energy, that fell to a record low in October of 2.5 percent. The bank predicts that inflation will track that decline, slowing to 5.4 percent next year and 5.1 percent in 2012, close to its targets.

The breakeven rate on Turkey’s CPI-linked bonds, which represents expectations of inflation over their lifespan, shows buyers have less faith. The securities have returned 21 percent this year, according to Merrill’s index.

The price of the bonds maturing April 1, 2020, of which the Treasury sold 3.1 billion liras ($2.1 billion) on Nov. 23, rose to a high of 119.1 kurus on Nov. 9 and was at 119 kurus yesterday.

It’s not the first time markets have doubted Yilmaz. When he slashed rates last year, economists including Turker Hamzaoglu of Merrill Lynch said Turkey risked falling “behind the curve.”

Weak Record

Turkey’s record for meeting inflation goals over the past five years is the weakest of nine emerging economies tracked by Barclays Capital, according to a Nov. 10 report by strategists including Koon Chow. In the period, inflation exceeded targets by an average of 2.9 percentage points, 1.2 points more than the deviation in South Africa, the second-worst performer.

Investors, though, should “give the bank credit” for accurate forecasting over the past two years, said Tevfik Aksoy, chief economist for the Middle East, Turkey and North Africa at Morgan Stanley in London. He predicts inflation will slow in the next three months.

“I would side with the central bank,” Aksoy said. “I don’t think linkers are that attractive.”

Also supporting the bank’s outlook is Prime Minister Recep Tayyip Erdogan’s budget restraint as he seeks a third term in elections due by July. The deficit for the 10 months through October was 23.1 billion liras ($15.7 billion), compared with a full-year target of 44.2 billion liras or 4 percent of output.

Higher Returns

Turkey’s growth and higher returns helped attract $13.5 billion of international investment in stocks and bonds in the first nine months, 17 times the year-earlier figure.

In that period, the benchmark ISE-100 equity index jumped 28 percent in dollar terms, more than triple the gain on the MSCI Emerging Markets Index. Yields on benchmark two-year lira bonds fell to a record 7.56 percent Nov. 22.

Company acquisitions also increased. In the past month, BBVA agreed to purchase 25 percent of Istanbul-based lender Turkiye Garanti Bankasi AS and Austria’s OMV AG announced plans to buy control of fuel retailer Petrol Ofisi AS for $1.4 billion.

Like South Africa’s Gill Marcus and other emerging market central bank governors, Yilmaz highlights the risks caused by investors borrowing in countries where interest rates are close to zero to invest in higher-yielding markets.

Exports Slow

Foreign investment helped push the lira up 9 percent against the euro this year. Europe is Turkey’s main trading partner, and export growth slowed to an average of 6.8 percent in the third quarter. Imports jumped 24 percent, swelling the annual current account deficit to $37.1 billion in September.

“Widening imbalances tell us there’s an increasing risk of a large currency correction,” said Lars Christensen, chief emerging market analyst at Danske Bank A/S in Copenhagen.

Inflation-linked bonds track consumer-price gains to compensate investors for the erosion of debt values. The bonds rise as consumer price expectations increase, sending yields lower, and coupons also rise in line with inflation.

The profit on the Turkish bonds this year is the highest among 18 countries tracked by Bank of America Merrill Lynch’s Global Index.

Kieran Curtis, who helps manage $2 billion of emerging-market debt at Aviva Investors, a unit of Britain’s second-largest insurer, said he has started to sell Turkish linked bonds after their “spectacular” gains. Speaking in a phone interview in London, Curtis said Turkey’s boom makes it “very unlikely” inflation will be below the central bank’s forecast.

“The current account deficit is growing, which suggests the economy may be growing above its capacity,” he said. “That doesn’t sound like a disinflationary environment to me.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE