Turkey $9 Billion Bond Rout Signaled by Swaps After Botched Coup

  • Turkey CDS spike past junk-rated Russia, Brazil since crisis
  • S&P Global Ratings cut Turkey to BB from BB+ on Wednesday

The thwarted coup attempt in Turkey is leaving derivatives traders with little doubt the country’s three-year sojourn in investment grade is coming to an end, potentially triggering a fire sale of almost $9 billion of bonds.

In the three trading days since President Recep Tayyip Erdogan survived a bid by a faction of the military to depose him, the country’s five-year credit-default swaps have soared above junk-rated Russia and Brazil while the lira tumbled more than any other currency in the world to record lows. The credit score implied by the swaps contracts is four steps below investment grade, according to Moody’s Analytics, one level lower than before the crisis erupted on July 15.

Moody’s said this week it’s reviewing Turkey for a possible downgrade of the Baa3 investment-grade status it awarded the country in May 2013, in light of the attempted coup. S&P Global Ratings cut Turkey one level to BB on Wednesday, putting it two steps into junk territory. A second speculative grade score from Moody’s risks prompting funds that can only own highly ranked debt to offload the $8.7 billion JPMorgan Chase & Co. estimates they hold in the country’s bonds.

"We have to be concerned that a downgrade to high-yield status could lead to possible forced selling," said Peter Marber, head of emerging-market investments at Loomis, Sayles & Company in Boston, which manages about $17 billion in developing-country debt and has has a market-weight exposure to Turkey. "Ratings agencies have been taking an increasingly aggressive stance on political risk in light of the decelerating global economy."

Rising Yields

Declines for Turkish local-currency 10-year bonds have driven up yields by 112 basis points to 10.2 percent since Friday, wiping out the previous seven weeks of gains. The cost of insuring the country’s debt against default has had its biggest four-day increase since June 2013, bringing the credit-default swaps to 296 basis points.

The lira weakened to as low as 3.0973 against the dollar Wednesday after the government declared a state of emergency and S&P cited concern over the deteriorating political environment in its decision to cut Turkey’s debt grade. S&P was the only ratings company to keep the country at speculative grade.

For analysis on Turkish debt volatility in the coming weeks, click here.

Brazil, cut to junk in February by Moody’s, has seen credit risk recede this year amid moves to impeach the country’s president. The credit-default swaps fell to 287 basis points on Thursday from as high as 533 in September. Russian contracts, which exceeded 600 in January 2015 in the aftermath of international sanctions and a wilting oil market, have dropped by more than half.

"Because the memory of the Russia and Brazil downgrades is so close, there is some concern in this regard causing an aggressive repricing of Turkey spreads," said Thibaut Nocella, who covers Turkey at Insight Investments in London, which manages about $4 billion in emerging-market bonds. Insight Investment is currently underweight in Turkey because valuations were already expensive before the current crisis erupted.

Smaller Deficit

While Turkish economic growth is forecast to slow this year, the country has narrowed its current-account deficit since 2013, as falling oil prices reduced its energy-import bill. Turkey’s debt burden as a proportion of economic output more than halved in the decade to 2015.

This improvement means Turkey may still avoid a downgrade, according to Tim Ash, a strategist at Nomura International Plc in London.

"It’s a review, it can go either way,” he said, referring to the Moody’s outlook.

Still, the political turmoil in the country has shattered optimism over the short-term prospects for Turkish assets. The lira will probably fall to 3.2888 per dollar within three months because"political risk has returned to Turkey with a vengeance," Societe Generale SA said in research published Wednesday.

Turkey will impose a three-month state of emergency as the government pursues those responsible for the failed coup, Erdogan said on Wednesday. The country won’t be under military rule, with army units taking orders from provincial governors, the president said in Ankara after a day of meetings with top generals on the National Security Council, and then ministers in cabinet.

"The consensus for going underweight Turkey is already happening," said Regis Chatellier emerging-markets credit strategist at Societe Generale.

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