Bond yields have touched record low levels in recent weeks, and there is growing evidence of concerns in the international press on the effects of a return to higher yields when this materialises.

Investors have been seeking refuge in fixed-interest investments pushing bond prices to all-time highs and consequently bond yields to record lows amid concerns of a double-dip recession in the US and possible deflation in the US and Europe. Moreover, yields declined rapidly since April 2010 on increased fears within the eurozone periphery stemming from the serious economic difficulties in Greece, Ireland and some other EU member states. While German bond yields declined reflecting their safe-haven status, the increased returns investors requested for holding onto bonds of these troubled European countries rallied to record levels with the Greek 10-year bond yielding above 12 per cent at one point.

The yield on the 10-year German Bund (the eurozone benchmark) dropped to an all-time low of 2.089 per cent on August 31 while the comparable yield on US Treasury bonds fell to 2.42 per cent - its lowest level since January 2009. The decline in sovereign yields internationally also impacted the local market with long-term Malta Government Stock prices reaching new highs. The longest-dated Malta Government bond, the 5.25 per cent MGS 2030, which had been offered on the primary market at par during the first week of August, rallied to a high of 104.66 per cent also on 31 August reflecting the surge in the eurozone benchmark bond.

The recent movements in the bond market reflect the markets perception of a prolonged economic downturn. However, international analysts have been highlighting the likely effects on the market should the opposite happen and economic growth in fact begins to improve. This would undoubtedly result in higher yields and hence a decline in bond prices, especially those in respect of longer-dated securities. Investors who are rushing into the long-end of the government bond markets now are likely to incur capital losses as bond prices decline from their record highs when the economic recovery begins and interest rates start rising.

Generally, bond markets are widely viewed as a safe haven when uncertainty reigns and the global increased demand for bonds was also felt locally. In fact, the recent Malta Government Stock issues attracted a large amount of applications from retail investors with no less than €84.9 million going into the 5.25 per cent MGS 2030. Interestingly, although the local Treasury offered two bonds (a short-term five-year bond and a new 20-year bond), the overwhelming majority opted for the longer-dated bond as a result of the higher coupon attached. Given investors’ primary objective is to seek an improved income, this is not surprising, however, at a time when interest rates are increasingly likely to start an upward move, short-term bonds should be in greater demand, as short-term bonds are less likely to suffer a drop in price when interest rates begin to rise.

Lower price volatility in shorter-dated bonds was also evident when the opposite happened and yields declined in recent months. The movement in Malta Government Stock prices showed that the larger capital gains were generated in the longer-term bonds while the upward movements in short-term bonds was more contained.

What about the local corporate bond market which has also seen increased demand in recent years? Are these likely to reflect the movements in the Malta Government bond market? Unlikely, since local corporate bonds did not participate to a large extent in the rally seen in Malta Government Stocks, presumably due to the lack of market makers in such securities. Furthermore, the majority of corporate issues are of shorter duration. Assuming the credit profile of local corporate issuers remains stable, currently attractive yields should lend support to the corporate bond market even when official interest rates start to move higher from current levels.

Investors needing to adjust their portfolio to include bonds of a shorter duration, thereby seeking income and protection should also consider using the medium of high dividend equities. The search for high yielding equities is gathering momentum across international markets with many analysts highlighting the companies offering above-average dividends and which are likely to continue paying such dividends in future years.

The 10 largest dividend-paying companies in the US produce a dividend yield of four per cent, which is one percentage point higher than the yield on 10-year Treasury bonds. Likewise, on the local market, the top three dividend yields offer net returns of between 4.45 per cent and 5.3 per cent per annum, and compare very favourably with the yield of 3.9 per cent on 10-year Malta Government Stocks.

The timing of the turnaround in the interest rate cycle has always been very widely debated and although there seems to be consensus that interest rates by the major Central Banks may only start edging up in the second half of next year, yields in the market are expected to rise by a larger degree and earlier in anticipation of the official announcement. Eurozone yields are expected to surpass the three per cent level within the next 12 months (up from the recent low of 2.10 per cent and the current level of 2.40 per cent) with the US 10-year Treasuries also expected to rise by more than 100 basis points from current levels. Expect wide swings across bond markets as a result of speculation on timing as we move closer to the day when interest rates do actually start edging upwards.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd, “RFC”, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the issuer/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

© 2010 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

www.rizzofarrugia.com

Mr Rizzo is director of Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

Sign up to our free newsletters

Get the best updates straight to your inbox:
Please select at least one mailing list.

You can unsubscribe at any time by clicking the link in the footer of our emails. We use Mailchimp as our marketing platform. By subscribing, you acknowledge that your information will be transferred to Mailchimp for processing.