Nicholas Birch in Istanbul -

Higher yields are tempting some investors back into Turkish bonds, but there's been no stampede.

About this time last year, Turkish bonds looked like the next big thing. The 15% yields on offer may not have been as high as the 2001 averages of 91.7%, but then – with the upward shift in Turkey’s credit profile - neither was the risk of losing your money altogether. “Buy Turkish bonds: they’ll deliver diamonds,” Morgan Stanley’s Serhan Cevik said at the time.

Following the turbulence in the financial markets this May and June, the mood is now more sober. Yields of 21% may have tempted foreign investors to the tune of $2.5bn over the last two months, with buying particularly strong for the benchmark 652-day Treasury paper. But that influx still hasn’t made up for the estimated $4bn of bond investment money that fled the country in May.

Part of the cause of the new timidity lies with the economy. Until this week, most analysts were expecting the central bank – which has displayed extreme caution since being wrong-footed in May – to begin gradually lowering interest rates from their current 17.5% early next year. Following the publication this Tuesday of figures showing the trade deficit continuing to grow, few now expect any change before the third quarter of 2007.

“The message seems to be that the rate hikes earlier in the year are still not really slowing imports or domestic demand that much,” Bear Stearns economist Timothy Ash wrote in a note to investors Thursday.

Much more importantly, Turkey faces political risk. Barely a year in, progress towards EU accession is in serious difficulty. Relations between the secularist establishment and religious-minded government were never easy, but they have deteriorated dramatically in the run-up to presidential elections next May. And with parliamentary elections also due before November next year, the government is looking increasingly susceptible to that most Turkish of political diseases – populism.

“In the medium term, Turkey looks strong economically”, says Deniz Gokce, an economist. “But that hasn’t stopped a fair few people out there from holding their breath.”

However, not all the news is bleak and the privatisation authorities took some of the pressure off after it reported this week that receipts from privatisation were likely to come in at a higher-than-expected $12.4bn in 2006, but decline to $5bn in 2007.

"The 2006 figure is a notable achievement, as the plan had been just $1bn-2bn billion, so this has provided a huge boost to the Treasury and helped offset higher debt interest costs from the May-June market sell-off," wrote Timothy Ash.

"It perhaps also explains why the Treasury is not desperate now to return to the Eurobond market this year - we think they will if the price is right to pre-finance 2007," he added.

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