After analysing the 2014 performance of the equity market in last week’s column, it is also worth looking into the developments across the bond market.
The Rizzo Farrugia MGS Index, which tracks movements in the bid prices of the Central Bank of Malta for all Malta Government Stocks listed on the Malta Stock Exchange, climbed by 8.4 per cent, closing the year at yet another new record level of 1,102.847 points.
Similar to the MSE Share Index, the Rizzo Farrugia MGS Index is also weighted by market capitalisation and therefore, the larger MGS issues have a bigger impact on movements in the MGS Index. The largest MGS’s are the five per cent MGS 2021 with €458.8 million in issue and the 5.25 per cent MGS 2030 with an outstanding amount of €440.2 million.
Due to the inverse relationship between bond prices and yields, an increase in the index represents a decline in yields and vice versa. The increase of 8.4 per cent in the index during 2014 is an exceptional performance and implies a strong rally in bond prices and a corresponding decline in yields. In fact, an analysis of some of the various MGS in issue depicted in this table shows the significant increase in prices during the last 12 months.
Few investors may realise the extent of the price rally with many of the longer-term securities climbing by over 20 per cent during the year while the new bonds listed in 2014 also closed at significant double-digit premiums to their offer prices. These changes only depict price movements and investors would also have benefited from the receipt of interest income during the year.
As prices rallied, yields slumped and this is evident from the movements on some of the reference bond yields. As an example, the yield on the 5.5 per cent MGS 2023 (a reference for a 10-year bond) declined from 3.19 per cent per annum in December 2013 to 1.65 per cent per annum in December 2014, a decrease of 154 basis points. Likewise, the yield on the 4.5 per cent MGS 2028 II (a reference for a 15-year bond) declined from 4.27 per cent per annum in December 2013 to 2.47 per cent per annum in December 2014, a drop of 180 basis points.
Some investors may question whether such movements are normal and sustainable. It is worth highlighting that it is unusual to experience such strong gains in bond prices in only 12 months. In fact, since the launch of the Rizzo Farrugia MGS Index in December 2010, the previous annual performances were -0.4 per cent in 2011, +1.7 per cent in 2012 and +1.2 per cent in 2013. The upturn in 2014 of 8.4 per cent is a clear outlier.
High levels of liquidity in the financial system is very likely to lead to another busy period of new bond issuance in during 2015
2014 can therefore be best described as an exceptional year for the bond market and eventually some of these gains will start to unwind as economic circumstances change.
The obvious question on many investors’ minds is when such a reversal in prices will start to take place. In order to analyse this, it would be best to see why such a rally in prices and a sharp decline in yields took place in 2014.
MGS prices generally move in line with changes in the benchmark yield across the eurozone, i.e. the German bund. The upward movement in Malta Government Stock prices therefore reflects a positive movement in German bund prices and a corresponding decline in eurozone yields.
During the first quarter of 2014, the decline in yields was rather gradual and the RF MGS Index only improved by 1.1 per cent. However, yields declined more rapidly during the second quarter on expectations that the European Central Bank would introduce new stimulus measures to combat the weak eurozone economic performance and increasing fears of deflation.
Bond prices rallied in early June when the European Central Bank announced a 10 basis point rate cut in official interest rates to 0.15 per cent. The previous interest rate movement had occurred in November , when the ECB reduced interest rates by 25 basis points from 0.50 per cent to 0.25 per cent. At the same monetary policy meeting in June 2014, the ECB had also decided to reduce the deposit facility interest rate to -0.1 per cent in a bid to spur an economic recovery and avert deflation. These measures led to a sharp decline in the 10-year German bund yield to 1.25 per cent by the end of June from 1.94 per cent in December 2013 and 1.57 per cent in March 2014.
Data from the eurozone in the first few weeks of summer continued to support the decision by the ECB at the June meeting and led to a further decline in yields in July and August as statistics from various countries indicated a weakening economic outlook including the all-important German economy. The rate of inflation across the eurozone also continued to decline and coupled with this, the escalating conflicts in Iran, Ukraine and other regions including North Africa supported a ‘flight to safety’.
The reference 10-year German bund yield slumped to a fresh low of 0.868 per cent per annum on August 28. Despite the surprise action by the ECB during the September monetary policy meeting of a further reduction in its main reference rate to a new record-low of 0.05 per cent, yields recovered in September mainly as a result of an easing of geo-political tensions.
Notwithstanding the slight recovery in yields during September, the RF MGS Index climbed by 3.3 per cent during the third quarter of 2014 as most MGS prices rallied. The brief upturn in yields during September proved to be short-lived as eurozone yields continued to decline to fresh lows during the final three months of the year dropping to as low as 0.54 per cent in the last week of December after the president of the ECB, Mario Draghi, hinted that the ECB would start quantitative easing possibly at the next meeting on January 22 (injecting cash into the economy by buying government bonds), to counter deflation.
The steep collapse in oil prices is adding to deflationary pressure. Moreover, deepening concerns about the Greek political situation also impacted sentiment across the bond and currency markets.
Given economic developments in the eurozone and also a challenging political landscape in some countries, it is very difficult to gauge when the situation in the bond market may start to change. In fact, eurozone yields continued to decline during the first few days of 2015 dropping to a low of 0.432 per cent on January 7. Although most international economists claim that interest rates will remain at current historically low levels until 2017, it is worth pointing out that secondary market bond yields will start to recover well before the first official interest rate hike by the ECB. As such, bond prices (especially those of longer-term securities) will start to decline before any official movement by the ECB. Investors must also understand that as longer-term bond prices performed more positively during the recent rally, they are likely to suffer a worse decline once the trend changes.
While MGS prices move largely in line with international bond market developments as evidenced in recent months and some corporate bond prices have also mirrored the same pattern, given the shorter-term to maturity of local corporate bonds as opposed to the longer-term MGSs, a reversal in corporate bond prices should be more contained. An eventual downturn in the years ahead may also be more subdued in the corporate bond market given the huge demand for fixed interest securities from an ever-growing investor base. This is likely to be maintained as interest rates on bank deposits are unlikely to rise before the next few years. This low interest rate scenario and high levels of liquidity in the financial system is very likely to lead to another busy period of new bond issuance during 2015.
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 company/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, and may also have other business relationships with the company/s. 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.
© 2015 Rizzo, Farrugia & Co. (Stockbrokers)Ltd. All rights reserved.
Edward Rizzo is a director at Rizzo, Farrugia & Co (Stockbrokers) Limited.