Article By Karl Falzon
On 1 September Reuters highlighted that German benchmark yields were at their highest level in 15 years, whilst Japan’s 10-year yield reached 3% for the first time since 1996. Since then, this month has seen sovereign yields climb even higher, with notably the US 10-year treasury yield now exceeding 5%, an almost 20-year high. Earlier this summer the Government of Malta issued 10-year debt at 3.80%, with the central bank’s indicative yield currently at over 4.20%. Meanwhile, the European Central Bank (ECB) raised interest rates by 0.25% last week to 2.50% for the second time in a few months and the US Federal Reserve raised interest rates for the first time in 3 years on Wednesday. Clearly, surging bond yields will remain a dominant consideration for investors.
Inflation is likely the main driver of the upward trend in yields. The ongoing conflicts have boosted the belief that the associated spike in energy prices will persist. This has been accompanied by concerns over second-round effects, including higher input and food costs, which could also be impacted by El Nino and drought conditions. Meanwhile, the economic performance of major economies has been healthier than was being predicted.
Within this context, markets are pricing in a more hawkish path from central banks. Whilst a second ECB rate hike had been on the cards, analysts noted the somewhat more hawkish-than-expected tone of ECB President Lagarde last week. The ECB highlighted that inflation (currently at 3.3%), will last for longer than the central bank was previously expecting. In the US, Fed Chairman Warsh claimed in August that officials will “have work to do” on inflation if they are not confident that pricing pressures are easing, and has now reiterated that inflation is still “too high”.
Fiscal considerations have also been impacting bond yields. Growing government deficits and expectations that funding requirements will remain sustained, are increasing the supply of sovereign debt. Country-specific considerations also play a role in this respect, with for example the French Treasury raising debt at elevated yields even compared to recent previous transactions. This aspect seems particularly applicable to the longer end of yield curves, and where such issuance is competing with the increased AI-related borrowings of corporates.
Meanwhile, it is positive to note that so far, risk assets and more specifically credit markets, have remained resilient. The rise in benchmark yields is inevitably putting pressure on already tight credit spreads, and expectations for returns are relying on elevated all-in yields and income generation. Dispersion is increasing and the importance of selection is more evident. However, so far credit has not experienced a major sell off. The asset class is also supported by relatively robust economic resilience and corporate health. It is also pertinent to note that primary markets have generally held up, with current forecasts showing that, at least in the US (which is being boosted by AI-related activity) the record 2020 levels could be achieved.
The Maltese corporate bond market has traditionally been one of the bright spots of the local economic and financial system, in terms of depth, relative stability and returns. Furthermore, in line with developments in other markets, the substantial movements in yields have not dented market sentiment. Issuance on the Malta Stock Exchange YTD approaches €375 million which is in line with the comparable period for last year, and indications are that the coming months could also be particularly active. In terms of pricing, a compression in spreads is observed, with the average new issue spread now estimated to be below 200bps.
Interestingly, and in line with the current thinking on a global basis, Maltese corporate credit is often viewed as an income-focused market, whereby the general level of coupons tends to dominate considerations related to spread. It will be relevant for investors to monitor how the market evolves in the coming months and seek opportunities accordingly.
In general, whilst the global yield repricing has so far not triggered a rotation out of risk assets (as was sometimes the case in similar past episodes), investors are still encouraged to avoid complacency. Potential sources of risks in such an environment include most directly the impact of higher borrowings costs for government debt sustainability, but also a spillover to fundamentals, corporate credit and other risk assets as financial conditions tighten.
Karl Falzon is head of capital markets at Curmi & Partners Ltd.
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 & Partners Ltd, with registered address Finance House, Princess Elizabeth Street, Ta Xbiex, Malta XBX 1102, is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.