The Rizzo Farrugia MGS Index was launched in December 2010 to enable market practitioners and investors to follow price trends in Malta Government Stocks.
While the MSE Share Index tracks the movement in prices across the equity market, the MGS Index tracks movements in the bid prices of the Central Bank of Malta for all Malta Government Stocks listed on the Malta Stock Exchange. Similar to the MSE Share Index which uses a market capitalisation weighting scheme, the larger MGS issues have a bigger weighting on movements in the MGS Index. Due to the inverse relationship between bond prices and yields, an increase in the index represents a decline in yields and vice versa.
The MGS Index started off this year on a very positive note and advanced by 2.2 per cent following an equally positive performance in 2013 with a rise of 1.2 per cent. In recent weeks the index regularly traded up to new record levels and exceeded 1,040 points last Thursday.
The upward movement in Malta Government Stock prices therefore reflects the decline in eurozone yields
The Rizzo Farrugia MGS Index had surpassed the 1,000 points level in November 2012. As such, the Index has increased by over 4 per cent in the past 18 months. This is simply a reflection of the price increases across Malta Government Stocks and investors would not only have benefitted from the capital gain on their bond instruments but also from the interest income accumulated during the period. As such, the past few years have been very positive for the many local investors who hold large exposures to Malta Government Stocks.
The index is based on the bid price quoted by the Central Bank of Malta on a daily basis. This is an indication of the price at which the Central Bank would be willing to buy limited amounts of each security. This indicative price generally reflects economic developments and interest rate expectations and not the demand and supply dynamics that many investors may expect. Although many prices on the market generally trade around the indicative bid price quoted by the Central Bank, it is worth highlighting that the market price sometimes varies depending on market circumstances. As such, if the supply in a particular bond exceeds the normal market size of circa €250,000 nominal set by the Central Bank, the price at which the Central Bank eventually bids in the market is a few basis points below the indicative price.
On the other hand, we have also seen some instances in recent months where the market price of some bonds is at a premium to the indicative bid price of the Central Bank since some investors would have wanted to purchase whatever is available in the market. The Central Bank also quotes indicative offer prices for some bonds where they have availability thereby providing a rather effective two-way market mechanism.
So what has been driving prices and the index higher in recent months? MGS prices generally move in line with the changes in the benchmark yield across the eurozone, i.e. the German Bund. The upward movement in Malta Government Stock prices therefore reflects the decline in eurozone yields.
In recent months, German Bund yields declined on expectations that the European Central Bank would introduce new stimulus measures to combat the weak eurozone economic performance and increasing fears of deflation. The eurozone economy is still clearly struggling and the tepid recovery varies remarkably from one country to the other. Economic growth across the entire region was disappointing with an increase in GDP of only 0.2 per cent during the first quarter of 2014. While Germany’s growth rate doubled, economic growth in France stagnated and Italy’s GDP contracted once again. Meanwhile, the problems of high unemployment across the region continued with the average rate of unemployment remaining close to its recent highs of 12 per cent (as at March 2014) and German unemployment unexpectedly rising last month.
Although the ECB may be comforted from a slight easing of deflationary pressures in April (the inflation rate rose to 0.7 per cent from 0.5 per cent in March), inflation remains significantly below their target of close to but below 2 per cent. The ECB had indicated that a rate of inflation below 1 per cent is a “danger zone”. It has been below this level since October 2013, mainly because of falling energy and food prices and the appreciation of the euro. Recently, ECB president Mario Draghi again stated that the bank is aware of the deflation risk and the ECB was equipped to get inflation back to its target again.
The ECB’s monthly monetary policy meeting is taking place today and many international economic commentators widely expect the ECB to announce a further reduction in interest rates by 15 basis points to 0.1 per cent following the recent data and comments from high officials at the ECB. There has also been widespread speculation that the interest rate banks receive on their deposits at the ECB (currently zero) will be lowered into negative territory.
This means that eurozone banks will be charged a fee to park their money at the ECB. Economists believe that such a measure will encourage banks to boost lending thereby possibly providing some momentum towards an economic recovery.
A rate cut by the ECB would also likely lead to a drop in the value of the euro which should also assist the economic recovery. In fact, last week the euro touched a fresh 16-week low against the dollar of $1.3584 per euro. The euro could weaken further if the ECB also engages in using unconventional monetary policy, i.e. quantitative easing, which was used by the other two major central banks in recent years to boost the economic recovery.
The Treasury issued bonds with maturities of over 15 years specifically targeted at retail investors
There are widespread indications that interest rates will decline and remain at these historically low levels for another two years. This implies support for bond prices at the current levels. However, investors must keep in mind that bond prices can also decline. The volatility in the Rizzo Farrugia MGS Index in May to July 2009, July to August 2010 and November to December 2012 proves this. It is also important for investors to understand that longer-term bond prices are more volatile and as these have performed very positively over the past few years, they will likely decline at a faster rate in the future once there are indications of a consistent economic recovery. Although an official increase in interest rates is unlikely before 2016, it is highly likely that secondary market bond yields will start to recover well before the first official interest rate hike by the ECB.
Local investors have become more exposed to longer-term government bonds in recent years as the Treasury issued bonds with maturities of over 15 years specifically targeted at retail investors whereas local corporate bond issuance was very weak. Irrespective of the duration, the yield attracted many retail investors to place excess liquidity in such instruments. The upward movement in prices in recent years, as reflected in the MGS Index, has so far rewarded investors handsomely. With an increasing amount of shorter-term and higher coupon corporate bonds available in recent months and others to follow imminently, it is curious to see if this week’s MGS issue attracted fewer retail investors. The results of the MGS issue will be published next Monday and one can then analyse whether the recent increase in corporate bond issuance has begun to negatively impact the demand for MGS by retail investors. Whatever the outcome, many local investors have exposed themselves to a higher allocation of long-dated bonds. Although it is naturally very difficult to time any reversal of this current bull market in bonds, investors must understand that this will eventually take place and therefore a ‘buy-to-hold’ strategy which was mainly the case to date, would not be ideal in an eventual rising interest rate scenario.
Edward Rizzo is a director at Rizzo, Farrugia & Co (Stockbrokers) Ltd.
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