Investors would have surely noticed the sudden decline in bond yields over the past 10 days.

The 10-year German bund dropped into negative territory on Tuesday morning touching a low of -0.03 per cent (its previous record low in April 2015 was +0.049 per cent), the 10-year UK gilt hit a new all-time low of 1.15 per ent also on Tuesday and last week,  yields on 15-year Japanese government bonds dropped below zero for the first time in history. It is interesting to highlight that yields on 10-year Japanese government bonds are currently at a low of -0.159 per cent.

The amount of sovereign bonds with negative yields has grown exponentially in recent months. In essence, investors are paying governments to look after their funds.

Credit rating agency Fitch estimates that the total level of debt with a negative yield has now exceeded $10 trillion in value, with Japan being the largest source.

German government bonds have negative yields up to a maturity of nine years.

Also in the eurozone, it may be rather strange that France and Belgium (two countries with uncomfortably large government debt burdens) have negative yields on bonds with maturities of up to seven years. Moreover, yields of two-year government bonds in Spain and Italy, which had experienced a rise in their 10-year yields to almost seven per cent a few years ago, are also in negative territory.

Prices and yields have an inverse relationship, so a decline in yields implies an increase in bond prices. The recent downturn in yields is therefore positive news for those investors who are already exposed to these sovereign bonds.

However, when yields are so low, total returns depend to a great extent on continuous price rises. This is the real danger for investors.

Many may be questioning why yields have dropped so steeply once again.

The new record lows in yields of various government bonds are primarily the result of central bank policies of very low or even negative interest rates, mainly in Europe and Japan.

Recently, however, international financial markets have again been affected by concerns about the global economic outlook following the weak jobs report in the US for the month of May. This dampened expectations that the US Federal Reserve will be raising interest rates during the summer months, thereby further driving down global bond yields.

The amount of sovereign bonds with negative yields has grown exponentially in recent months

The decline in yields across Europe is also a result of the commencement of the corporate bond-buying programme by the European Central Bank.

The ECB had first announced this new measure on March 10 but this came into effect only last week. Ahead of this move by the ECB, borrowing costs of highly-rated European companies eligible under the programme declined rapidly with more than €36 trillion worth of corporate bonds already trading in negative territory.

Moreover, political issues are also taking their toll with the primary concern currently being the vote on Brexit taking place on June 23. The outcome is very uncertain with some of the recent polls indicating that the ‘leave’ camp has a small lead over the ‘eemain’ campaign. Analysts at the US bank Citigroup were quoted in the media as having stated that if the Brexit vote confirmed an exit, the 10-year UK gilt could drop towards the one per cent level as investors would expect the Bank of England to cut interest rates to compensate for the potential decline in domestic demand – and a renewed recession.

In previous articles, I explained that prices of Malta Government Stocks mirror movements across eurozone bond markets. So given the above movements in German bund yields, some investors may rightly be confused at only the mild upward movement in MGS prices. While it is true that last week the Rizzo Farrugia MGS Index advanced to its highest level in eight weeks as MGS prices also strengthened, it is still surprising that a number of bonds have not surpassed their previous highs reached last year and earlier in 2016 despite the sharp decline in German yields.

This anomaly was the topic of my article some weeks ago. One plausible reason is that, at times, the Central Bank of Malta which publishes indicative bid prices across the various MGS in issue and on which the Rizzo Farrugia MGS Index is based, also takes into account the movements in the eurozone periphery bond markets. In fact, while the 10-year German bund yield dropped to its lowest level on record last week, there was only a slight decline in the 10-year yields of Spain and Italy – two eurozone member states with similar credit ratings to that of Malta.

However, one should also question whether Malta is due for a credit rating upgrade given its recent strong economic performance and the decline in debt metrics especially following the developments at Enemalta. Should rating agencies indeed reflect this via an improved credit rating in the months ahead, then one should expect the MGS market to emulate the trends in the German bund market more closely in the future. This would be positive news for the Treasury of Malta since it can then borrow from the market at lower rates of interest but this is naturally bad news for investors who have a general preference towards MGS.

The problems for investors due to the negative interest rate environment have also been explained in some of my articles over previous months and also regularly in the international press.

Last week, the legendary bond investor Bill Gross warned again that the current environment of negative yielding bonds is “a supernova that will explode one day” as even a small rise in yields in the future could have very negative repercussions for investors. The US investment bank Goldman Sachs was quoted in the international media as having calculated that an unexpected one percentage point rise in yields of US Treasuries would trigger losses of up to $1 trillion for investors. Many other international investors have been expressing fears of an eventual reversal of yields with some stating that “negative interest rates were distorting financial markets and economies which may lead to potentially dangerous consequences”.

One should question whether Malta is due for a credit rating upgrade given its recent strong economic performance and the decline in debt metrics following the developments at Enemalta

The maximum danger for bond investors will come when economic growth across the eurozone strengthens and US inflation rises. This is what will cause a sudden reversal in yields across global bond markets.

Since bond prices and yields move in opposite directions, if these negative or low yields turn sharply upwards, bond prices would fall and bondholders stand to incur losses.

It is important that local investors keep abreast of what is being discussed across international financial markets about recent unprecedented developments.

Investors should not be complacent and seek professional advice to ensure that their investment portfolios are structured in such a way to satisfy their investment objectives within the prevailing market developments.

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

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.

© 2016 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

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