The fact that interest rates are at an all-time low, especially in the short history of the local bond market, is known to all investors. Given such a scenario, the following question are interesting to consider:

• Are all investors factoring in the possibility that interest rates could go up?
• Are they factoring in the situation that they could be stuck with a lower yield than what they could get on the market once interest rates did in fact go up?
• Are they appreciating the fact that if interest rates go up the companies borrowing at the low rates might not afford to refinance their bonds at a higher rate?
• Are the low interest rates and such high demand for any return attracting the wrong bond issuers?

The post will expand on the above questions and other related issues focusing around the local bond market, low interest rates and the high demand for interest paying investments.

The Local Government Bond Market

Following the latest movement of falling interest rates that begun in the aftermath of the 2007-09 financial crisis we have seen the local government issue bonds that are longer dated and have lower interest rates than ever before. These two factors increase the interest rate risk of holding such bonds. But with not many alternatives around the demand for Malta Government Stocks (MGSs) has been consistently strong.

Looking at the yield to maturity (YTM) on the MGSs one would see that it is less than 1% for all bonds with a maturity until 2028. Furthermore, the YTM on the MGSs beyond 2028 goes up to a maximum of just 1.88% which is for a bond maturing in 2041[1]. What this effectively means is that the Maltese government can borrow for a period of over 25 years at a cost of less than 1.9%. The major risk here is that within a period of 25 years a lot can happen, including an increase in interest rates.

Let us take a scenario where interest rates went up by 2% in 10 years’ time and use the 2.40% MGS 2041 as an example. So in 10 years’ time the maturity of the bond would be 15 years away. The current YTM on a 15 year MGS is around 1.15% when the base rate (as determined by the European Central Bank and upon which all other interest rates are calculated) is 0%. So if the base rate had to go up to 2% in 10 years’ time we can assume that the YTM on a 15 year MGS should be around 3.15% (i.e. 2% higher). For the 2.4% MGS 2041 to be yielding round 3.15% in 10 years’ time its price has to go down to around €91 per 100, which is almost 18% lower than the current price.

Of course the above is just assuming that interest rates go up by 2% in 10 years’ time, this could be argued to be a conservative approach. So what would the situation be if interest rates went up by 2% in 5 years’ time instead of 10 years’ time? The price of the 2.4% MGS 2041 would go down to around €80 per 100, representing a fall of around 27% from the current price.

The Local Corporate Bond Market

Corporate bonds are bonds issued by companies, so on the local bond market it includes any bond that is not an MGS basically. In this area we have also seen a predicted move toward issues of lower interest coupons and the maturities have more or less been at a standard of 10 years. It is much less easy to compare different corporate bonds than it is to compare different MGSs. This is so since different entities will have different risk factors, while MGSs are all issued by the same government of Malta.

So not every issuer is as safe as the rest, for example an issuer who has just one project in Libya is considered much riskier than an issuer that has a diversified portfolio of assets that generate income streams from different markets. The problem is made much worse when interest rates are so low that many issuers are attracted to the market and demand is so high for any interest yield that almost every issue gets over-subscribed.

Such a scenario could create a very devastating outcome when all issuers are able to borrow at below risk-adjusted rates in the current market. The risk here is that if interest rates had to go up by the time such issues mature the company might not be able to re-finance its bond at a rate its cash flows could afford. So for example, we have the upcoming Premier Capital bond maturing which will be rolled over. In the company announcement it was stated that €24.6mln of the old bond will be exchanged for €65mln of a new bond. Assuming the usual 10 year bond maturity is chosen and considering the YTM on the currently existing corporate bonds, it is not difficult to assume that the coupon interest rate on the new bond will be below 4%. One can argue that since the coupon is so much lower the company can afford to actually borrow more (the old bond had an interest rate of 6.8%). This is all well and good, but €65mln is considerably more than €24mln so the interest expense will definitely be higher.

The point I am trying to make is the potential problem that could exist in 10 years’ time when this new bond matures. What would happen if interest rates had to go back up to what they were 10 years ago when the initial bond was issued – would the company afford to refinance such a large amount of borrowing at a higher interest rate? Would investors panic if interest rates go up by 2% in 5 years’ time and the price of the bond would fall to the lower €90s per 100?

I have used the Premier Capital bond just as an example since it is the latest issue to be coming to the market. This is not the riskiest bond issue on the market which actually makes the whole situation worse. In reality there are many other bonds that could suffer the same fate if interest rates had to go up. So what could result would be a simultaneous fall in price of local bonds. Imagine a situation of many bonds on the market falling towards the mid to lower €90s per 100 meaning that investors would be down say 7-10% from the current prices of their bonds. Would we have a situation of a rush to sell such bonds? Considering the fact that such bonds could get very illiquid very fast the prices could go well below the theoretical prices I am assuming here. To make matters worse funds and other investment vehicles that invest into the local bond market which may hold large amounts of the issued bonds could be making the whole situation even worse. If faced with a lot of redemptions at once due to the potential quick fall in the price of these funds an even worse fire-sale situation could ensue.

The Bottom Line

In conclusion it must be stated that the above is all based on assumptions that interest rates go up within the medium to long term. This can very well be the case, but we could also have a prolonged period of low interest rates. In reality it is anyone’s guess and no economic model can accurately predict the reality we will experience. The key to lower one’s risk is to stick to the safer bonds with the shortest maturities and to diversify the portfolio as much as possible. Such a scenario is not favourable to the buy-and-hold investor who would buy a bond with the intention of holding it until maturity. Thus it would make sense to take profits when prices have risen to a decent amount and crystallise such profits by actually selling the position. By doing so and reinvesting into new issues on a regular basis an investor could lower the risks I have focused on here, but they would not be eliminating them. As usual, please refer to a professional investment advisor before taking any investment decision and the usual risk warning applies that nothing presented here is actually investment advice.

 

[1] Figures are as at 21^st October 2016