The term “great rotation” was originally penned by an economist at Bank of America Merrill Lynch in an October 2012 research note titled The Bond Era Ends. It refers to the prediction that the record-low bond yields will prompt investors to rotate out of sovereign bonds and into shares during 2013 and in future years.

The bull market in international bonds intensified in recent years following the various global macroeconomic issues in the aftermath of the bankruptcy of Lehman Brothers that prompted investors to seek “flight to quality” and invest in safe haven assets. This created a surge in sovereign bond prices and a resultant decline in yields to all-time lows.

The situation in Malta to a large extent reflected the developments across international markets, especially the eurozone. The eurozone benchmark yield, the 10-year German bund, dropped from a level of around 4.5 per cent before the start of the financial crisis in 2008, to as low as 1.126 per cent in July 2012.

With yields falling so low, it is inevitable that in the years ahead, these will rise and prices will subsequently fall from current record levels. In fact, eurozone yields regained the two per cent level on September 5 for the first time since March 2012. This movement was also reflected in the Malta Government Stock market with prices, especially of the longer-term securities, becoming increasingly volatile and declining from their record highs of recent weeks and months. This is very evident from the Rizzo Farrugia MGS Index which tracks movements across the local sovereign bond market.

Although it is widely argued that official interest rates by the major central banks will not rise before another few years, bond prices will become increasingly volatile and a downward trend should be expected well before an official movement in rates.

As indications emerge that the global economy will gradually pick up some positive momentum and some of the major risk factors such as the eurozone debt crisis become less worrying, the “flight to quality” seen in recent years is bound to reverse and investors will be inclined to take on greater risk. Investors holding large exposures to bonds, especially long-term sovereign instruments, must be aware of the expected decline in prices. Many local investors are likely to be in such a situation given the issuance of long-term bonds by the Treasury in recent years at “relatively attractive” rates of interest. The slowdown in issuance across the local corporate bond market and the decline in fixed-term deposit rates of the major banking institutions exacerbated this movement into long-dated instruments. Investors should therefore consider suitable alternatives to protect the current value of their portfolios.

A valuation yardstick widely used by many international financial analysts is the comparison between 10-year sovereign yields and the dividend yields offered by some equities.

When dividend yields of companies are above the yields of the 10-year government bond, this indicates that the relative valuation of equities is attractive.

The yield to maturity of a 10-year MGS of 3.2 per cent per annum before tax (2.75 per cent after tax) is currently well below the dividends offered by a number of local equities. This table shows the historic dividends based on current prices of some of the local companies that have regularly made distributions to shareholders over the years. The comparison may be surprising to many and should encourage some investors to lock-in profits on Malta Government Stocks (before the decline in prices accelerates) and to allocate proceeds to such equities to secure dividends which in many cases surpass the net interest yields on Malta Government Stocks.

Two other companies that have similar attributes but currently cannot be compared to the ones indicated in the table due to their short track record are Malita Investments plc and TignéMall plc.

Both companies conducted an initial public offering over the past year with similar business models offering sustainable dividends to shareholders in future years. These companies ought to continue to attract the attention of those investors who wish exposure to instruments with similar characteristics to a bond.

Malita have already distributed two dividends to shareholders while Tigné Mall plc recently indicated that the company is well on track to pay the final dividend anticipated in the Prospectus published earlier this year. At the time of the IPO, Tigné Mall stated that the net yield based on the offer price of €0.50 per share is expected to amount to four per cent (5.9 per cent before tax) for the 2014 financial year rising to over five per cent in respect of the 2017 financial year.

With yields falling so low, it is inevitable that in the years ahead, these will rise and prices will subsequently fall from current record levels

It is still too early to conclude that the great rotation is already taking place in Malta, however, there is clear evidence that trading activity in the local equity market has increased. Statistics indicate that there was a 60 per cent increase in equity volumes between January and August 2013 over the comparable period last year.

The international equity markets also offer opportunities to invest in multinationals that have long-established businesses and sustainable dividends for shareholders. Some providers of Exchange Traded Funds also have specialised instruments investing in such dividend-paying companies.

Other possibilities for investors to protect the value of their portfolios are to consider corporate bonds of a shorter-term duration than Malta Government Stocks which mature beyond 15 years’ time. New corporate bonds being issued at 100 per cent (par) at relatively attractive rates of interest should be more insulated from a downturn in bond markets. As such, investors should also consider capitalising their gains on Malta Government Stocks currently priced at a premium to par and to reinvest in new bonds at 100 per cent (par).

Following the current fixed interest offer by Medserv plc, other new investment opportunities are expected to be available to investors following the latest amendments to the listing policies by the Malta Financial Services Authority. Moreover, companies are increasingly likely to want to diversify their funding options away from a total dependence on banking institutions.

Although the great rotation has been among the investment themes touted for 2013 and future years, it is difficult to ascertain whether international investor flows out of bond markets and into equity markets are as a result of this shift. Some financial analysts argue that such a rotation could be derailed by an unexpected slowdown in the US economy, a revival of Europe’s debt crisis, adverse economic developments in China, or any other development that would cause investors to once again seek the relative safety of bonds.

Whatever the immediate outcome, bond and equity markets are evidently braced for challenging and more volatile times ahead. Investors therefore need to be aware of upcoming developments and risks and review their portfolios more regularly to position them to preserve their capital and achieve their longer-term objectives.

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 from 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.

© 2013 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

www.rizzofarrugia.com

Edward Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

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