It is no secret that in Malta investors tend to prefer fixed income products and tend to shun away from investing into shares, even more so if they are foreign shares. However, given the current scenario where interest rates are virtually as low as they can be and with the possibilities of rate increases in the coming months/years – does it make sense to be 100% in fixed income?

What do low interest rates mean for fixed income investments?

The fact that interest rates are low presents two major problems for fixed income investors. Both problems are intrinsically tied to the inverse relationship between bond prices and interest rates. As was discussed in a recent post when interest rates fall, the price of existing bonds rises. This has been in effect over the last years, since central banks around the world have been cutting interest rates and the prices of bonds have been rising. 

What this means for an investor who wishes to buy a bond is that prices are high and yields (i.e. returns) are low. In some instances, such as certain German Government bonds, we even have a situation of negative yields. This means that if you buy the bond, since the price is so high and it will eventually mature at a price of €100 per 100 bonds, even if you consider the annual return from the interest you will receive, you will still end up with less money. 

This is just one of the problems when faced with low interest rates. The other major problem is that if an investor holds bonds currently, once interest rates start to go up, the prices of his bonds will go down. An important factor to consider here is the fact that the more longer dated the bond is, the higher the risk of the price of that bond going down. So even if an investor buys a really safe bond that has very little risk of defaulting, that investor would still have to suffer a capital loss if he/she wanted to sell his/her investment before maturity.

So to sum up, if an investor buys a bond today, such an investor would be earning a low interest return and would also be taking on the risk of being stuck with that low return even if interest rates go up.

An Example of a Long Dated Bond and an Interest Rate Increase

Let us take as an example the latest issue of the Malta Government Stock (MGS). Earlier this year the government issued a 3% bond that matures in 2040, making it a 25 year bond. The bond is currently trading at a price of €106.50 per 100 bonds. So basically anyone who bought it at a price of €100 when it was issued, is currently making a profit of 6.50%.

As a new investor however, if one wanted to buy into these bonds, such an investor would be paying a premium of €6.50 per 100 bonds bought since at maturity the bond swill pay out €100 per 100 nominal. So there would be a known one time capital loss of 6.50%. However, one would also earn 3% per annum on the nominal amount of bonds bought. By using a YTM Calculator we can easily work out that the yield to maturity would be around 2.65% on this bond. This means that if the investor buys the bond today and holds it until it matures he/she would earn an equivalent of 2.65%.

Now imagine that 5 years pass and the base rate, (that is, the rate set by the central bank on which other interest rates are based), goes up from the present 0.05% to say 2.50%. So as a quick rough estimate, if with a base rate of 0.05% the government of Malta can borrow until 2040 at a rate of 2.65% (the YTM). Then if the base rate goes up to 2,50%, the same government of Malta would have to offer around 5% interest on a bond maturing in 2040.

So how would this affect our current bond holder who bought the 3% MGS 2040? Badly – very badly.

If an investor could earn 5% on a new government bond that matures in 2040, the yield of the existing government bond he holds has to go up to 5% as well. For the yield to go up to 5% on our original 3% MGS 2040 bond the price has to go down so that new investors can make a capital gain on top of the 3% per annum interest. One might reason that this difference would not be that much since the difference between 3% interest and 5% yield is just 2%. The problem is that 2% difference has to be achieved over a period of 20 years!

So if we simply use a Bond Price Calculator to see what price the 3% MGS 2040 has to be in order to yield 5% if bought in 2020 we get a result of around €75! This means that the bond holder who opted for the long dated yet very safe investment can only sell his investment for a loss of around 30% (considering it was bought at €106.50 and sold at €75). One may argue that if the investor does not sell the bond and simply keeps it, that investor would just lose the 6.50% capital loss and still earn his full 3% per annum. This is true, however it must be pointed out that the same money that is earning that investor 3% per annum could have been earning him/her 5% per annum in our scenario. Multiply this 2% difference by 20 years, that is a total difference of 40% in interest lost.

This example begs the following questions:

• Are local bond investors prepared for interest rate increases?
  
• Is the local bond investor mature enough to recognise the different types of risks involved in investing into bonds besides the obvious risk of default of the issuer?
• Are investors buying any locally issued bond recklessly?

The Bottom Line

At the end of the day, investors seeking a fixed income have come to accept the fact that interest rates are low and will probably remain so for the coming years. Although interest rate increases are expected from next year in Europe, they are not expected to be drastic and nobody really knows when and if they will actually happen.

Furthermore, investing into bonds still is normally considered one of the safest options, however one has to appreciate that there other risks when investing into bonds besides the risk that the issuer defaults. In practice the default risk as it is known is one of the least factors that affects investors since through diversification and through the selection of good quality issuers this risk is normally seen to. In reality most investors are currently mainly subject to interest rate risk and maturity risk. I had already discussed the risks of investing into bonds in a recent bonds which you can access here.

KD

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