Nothing comes for free and investments are not an exception. Investors expose themselves to risk in return for a reward, which usually comes in the form of a dividend, a coupon or a capital gain. The relationship between risk and return is critical and an investor will try to acquire financial assets which pay the maximum amount of return for any given level of risk.

Maltese government debt pays roughly double the rate paid by the Austrian government

In this context we analyse the risk-return ratio of government bonds across the eurozone. The rationale behind this study is simple: the Maltese public is the main customer of Maltese government bonds. Are investors getting enough for their money?

Bonds carry with them two main risks. The first is market risk – or the risk that the change in interest rates decreases the value of a bond. Let’s say a bondholder acquires a bond paying a coupon of five per cent and the next day the same issuer issues a bond with similar characteristics and prices it at six per cent.

The bondholder might kick himself – had he waited for a day, he could have bought a bond that pays a higher rate of return. However the interest rate risk is not relevant to our study because the interest rate risk applies indifferently across the bond universe. In other words, if interest rates rise, the rise will indiscriminately affect bonds issued by any Eurozone issuer.

The second type of risk is credit risk and this is determined by the order of government finances, the productivity of the nation and the ability of the nation to service its debt. The EU periphery debt fiasco clearly manifests this type of risk. Credit risk is usually assessed on the basis of ratings assigned by credit rating agencies however we also looked at other fundamental indicators. The table sets out the yields and risk indicators of eurozone countries.

We draw a number of observations from this short case study. Firstly, the Maltese government pays higher yields than Belgium and France and yet Belgium and France have higher unemployment rates, higher deficits and larger government debt levels.

Secondly, the Italian and Irish government yields are roughly 0.5 per cent higher than the Maltese government yield. This is a relatively small premium in the context of the risks inherent to Ireland and Italy. The GDP growth rate is weaker in the case of Ireland and negative in the case of Italy, the unemployment rates of Italy and Ireland are more than double the rate of Malta and the government finances of Italy and Ireland are much more vulnerable than those of Malta. And yet Maltese government bonds only pay 0.5 per cent less.

The government bond yields paid by these troubled countries have been systematically pushed down through ECB intervention. Ironically, such intervention makes the holding of periphery government bonds less attractive because the inherent risks of these nations remained unchanged but the investor receives a lower return.

Another interesting observation is that the Maltese government debt pays roughly double the rate paid by the Austrian government. Austria enjoys a sterling AA+ rating but apart from the fact that the Maltese unemployment rate is 2.4 per cent higher, the fundamental indicators of the two countries do not vary widely. Even though Austria should be safer, the additional premium that a Maltese government bond pays is arguably more than sufficient to offset the additional risks inherent to Malta.

The MGS market is less liquid than issuances of most other eurozone government stocks. Less liquid stocks usually pay a liquidity premium in order to compensate the investor for this risk and possibly this premium partly accounts for the higher yield paid by the Maltese government.

Source: Eurostat, Standard & Poor’s

Notes
(1)  Central government bond yields, gross of tax, with a residual maturity of around 10 years. Yields refer to January 2013 monthly averages. No data was available for February 2013 monthly averages at the time of writing.

(2) According to the ECB, there are no Estonian sovereign debt securities that comply with the definition of long-term interest rates.

(3) Forecast according to Eurostat.

The views and opinions expressed in this article are solely of the authors and do not reflect the views of the users of the website, its affiliates or of any financial institution. This article is published solely for informational purposes and is not to be construed as a personal recommendation, a solicitation or an offer to buy or sell any securities or related financial instruments.

Chris Grech and Calvin Bartolo are co-founders of financial website http://blackdigits.com.mt .