Article by David Curmi
There is no doubt that it has been a fantastic ride for those who have been lucky enough to have been on it. I refer here to the bond bull market of the last 30 years or so. A shorter ride, if Malta Government Stocks (MGS) was your chosen vehicle, but still highly profitable none the less.
The big question however is where to from here? The last 18 months have seen some unprecedented moves in the European bond market, driven in large part by the European Central Bank’s Quantitative Easing (QE) program. This acted as a major support for government bond prices. Local MGS was no different. Prices rose to record levels with some of the higher coupon and longer dated bonds trading at premiums of 55% to their nominal value. These moves were justified by the scramble for yield that investors were coerced into. As interest rates on bank deposits vanished, savers were left pondering where to park their funds. Government bonds were a major beneficiary, not only because investors sought to earn a return by way of the coupon that was being paid but also through the capital gain that was easily made as prices of these bonds trundled ever northwards.
In the last quarter of 2016 this seems to have changed. Long dated bonds that were trading at significant premiums are today trading almost 10% below their highs. Other bonds followed a similar pathway. This is not a reflection of a change in the credit quality of these instruments. In fact in October the government’s credit rating was indeed raised by S&P to A- from BBB+ with a stable outlook envisaged. It was more likely due to a change in the outlook for interest rates, reflecting largely events taking place in Europe, and the US. Primary amongst these were a realisation that QE in Europe has largely run its course with Draghi pointing to governments to do their bit with fiscal stimulus, as perhaps we are about to see in the US. Additionally, economic numbers in the US and Europe have continued to point to continued growth and potentially some inflation. Unemployment is down significantly from its high in Europe and confidence in the economic outlook remains strong. It is the political scenario that is perhaps less certain at this junction and with surprises such as Brexit and Trump now part of history it is not inconceivable that we get one or two unexpected outcomes in Europe. Each of these could have its own bearing on where yields go but to my mind none are likely to lead to a fall in yields on MGS.
As I sit here writing this article the Maltese government is in the midst of issuing new bonds. In recent issues these would have been snapped up in hours. This time feels different. There is no rush and I would indeed be surprised if financial institutions are squeezed out by retail investors as has been the case for the last few issues. This is perhaps a sign that we are returning to a situation of normalisation as retail investors do not see the opportunity to “stag” the issue. If however there is no confidence that the price of these bonds will go up, or at least hold their own then can investors continue to consider them as attractive investments?
This is where investors need to be more discerning in their choice of investments. Going forward it is becoming more evident that a change is happening or perhaps has already happened. The expectation that interest rates are still on a downward trend is slowly reversing or has indeed bottomed out. The implications for holders of MGS firstly and then bonds in general, is significant as this could lead to a long term downtrend in bonds. Do not forget that just as MGS prices rose to substantial premiums, it is conceivable that they will fall to, possibly, big discounts in certain scenarios. Investors searching for income need to reassess their strategies. The question as to whether you are agnostic about seeing the price of your investment fall whilst you are collecting the interest will come to the fore. For many investors loss of capital on their bonds is a new experience and the tendency is to adopt a “wait for the recovery” scenario. This could be a long painful wait. Welcome to Purgatory.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.