Will the Turkish Twist Continue to Hinder Emerging Market Debt?

Turkey is currently facing serious financing problems, and investors in emerging market debt (EMD) have clearly taken note. Turkey has borrowed heavily in currency markets through its issuance of foreign-denominated debt, much of it in U.S. dollars. The value of the Turkish lira has fallen sharply this year relative to the dollar, making the debt costlier to repay and forcing investors to question whether Turkey has the capacity to fulfill its financial obligations.

Concern around Turkey has prompted increased risk aversion from fixed income investors, cheapening EMD broadly. This risk aversion is evident when comparing EMD to the domestic high-yield bond market, as shown in the LPL Chart of the Day. On August 13, the yield advantage of high yield over EMD fell to just 0.01%, its lowest level since 2005, indicating serious investor concern about mounting troubles in Turkey.

High Yield's Yield Advantage to EMD Reached Lowest Level in over a Decade

High yield has historically yielded more than dollar-denominated EMD, as the credit ratings of emerging market debt issuers are generally much stronger than those of high-yield issuers. However, in periods of stress, investors sometimes sell first and ask questions later. Turkey’s currency crisis has led to a cheapening of EMD, regardless of the credit rating of the issuers.

“Thus far, there has been limited contagion to other countries, but the broad EMD space has experienced some pressure and investors must remain vigilant against the potential for mounting risks,” said LPL Research Chief Investment Strategist John Lynch.

Even though EMD has cheapened relative to lower-quality alternatives (such as high yield), we still remain cautious on the sector for its exposure to currency fluctuations, protectionist trade policy, and country-specific risks for which we believe investors are still not amply compensated.

Be sure to read our Bond Market Perspectives, due out later today, in which we discuss Turkey’s issues and their impact on fixed income markets in more detail.

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International debt securities involve special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards. These risks are often heightened for investments in emerging markets.

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