(Bloomberg) -- Turkey’s high inflation is making a rising star out of a niche bond indexed to a central bank rate, leaving overseas investors with few reasons to buy other parts of the market.
So-called TLREF notes, indexed to the overnight reference rate set by the Turkish central bank, are increasingly popular among foreign fund managers searching for extraordinary yields in emerging markets. The bills have been relatively difficult for foreigners to obtain or sell as until recently they have been primarily held by local banks for balance-sheet management rather than trading.
TLREF notes offer a yield of around 50%, in line with the central bank’s policy rate, the highest in the world after Venezuela. For investors who see Turkey’s inflation fight as a longer-term challenge, requiring interest rates to stay high into next year, that makes TLREF bonds compelling. In comparison, yields on Turkish 2- and 10-year notes were trading at 42.1% and 28.7%, respectively, as of Thursday, well below that level.
“I prefer TLREF bonds for the yield,” said Kieran Curtis, director of investment at Abrdn in London. “It’s close to a 20 point drop in compound yield to own fixed-coupon bonds compared to this. That’s a lot of rate cuts.”
The idea behind the trade is that Turkey’s central bank will need to stay hawkish in its fight against price increases for a longer period. Inflation climbed as high as 86% in October 2022 and peaked again at 75% in May this year. Most of the traders who prefer TLREF bonds over traditional debt see no rate cuts on the horizon.
“I don’t expect a cut this year,” said Curtis. “I pencil in cuts starting fairly early next year.”
Hawkish Signals
The central bank held its policy rate for fifth month in August while sending hawkish signals for upcoming meetings. The monetary authority last raised rates in March, by 500 basis points, in a bid to tame inflation.
Guillaume Tresca, global emerging-market strategist at Generali Asset Management in Paris, also says he doesn’t expect rate cuts anytime soon as the disinflation process will be long and policymakers need to maintain high rates to reinforce credibility.
“If you start cutting too early, you can lose all the benefits of the previous decisions,” he said in an interview. As a result, Turkish fixed-income lira bonds have less allure for investors than they did earlier this year, since the hard part of the inflation fight still lies ahead while most good news is now priced in, he said.
“Turkish bonds, both dollar and lira government bonds, are less attractive,” said Tresca. Good news is factored into dollar bond pricing, while “lira government bonds are not so cheap, given challenges over disinflation.” He said it’s better to focus on the short-dated section of that market.
Diverging Demand
The diverging demand for the different types of bonds was visible in the latest auctions this month. Demand for 4-year TLREF bonds reached 63.2 billion liras ($1.9 billion), while bids for fixed-rate notes due 2033 amounted to just 13.4 billion liras.
“Turkish authorities have conducted the right policy, but it’s still a long journey,” Tresca said. A sharp fiscal adjustment and a structural decline in inflation beyond base effects are “needed to enter into new Turkish asset positions.”
AllianceBernstein Holding LP also says that Turkish fixed-rate lira bonds won’t be an attractive investment for at least six months amid higher-than-expected inflation and further weakening in the currency.
(Updates with current bond yields and chart)
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