The Maltese Government Stocks (MGS) have been on the decline for quite some time now. In fact, if we look at the performance of the whole MGS market, it has lost in the region of 14.7% from the start of the year until July 15. Some local investors may find this huge drop a phenomenon, but for the world of finance this was expected especially given the unprecedented times we are living in.
What caused this dip in MGS?
The main reason for this sharp decline in bond prices is the expected rise in interest rates that accelerated throughout bond markets this year, as inflation took off. The interest rate environment has changed dramatically during this year. We have experienced yields for most fixed income markets spiking up, which is considered a negative development for bond investors because of the inverse relationship between bond yields and bond prices. Bondholders were hard hit by this environment during 2022.
Several global events have changed the landscape during this year. Inflation threats, which led to a substantial shift in monetary policy by major central banks, together with Russian invasion of Ukraine were viewed as a material change to investors’ views. The surge in inflation is mainly a repercussion of an aggressive monetary and fiscal stimulus during 2020 and 2021, rising demand and supply chain disruptions.
This is reflected in inflation figures where large and major economies are reporting inflation data that is the highest during the past four decades. High inflation is the case for Malta as well, where it is expected that the inflation rate in 2022 will be in the region of 4.50% to 5% year-on-year. Movements in interest rates tend to follow inflation trends. If inflation moves higher, interest rates tend to follow suit.
Locally, inflation is expected to be significantly higher than 2021 levels, primarily due to higher services and food prices. Malta has so far remained unaffected by the sharp increase in international wholesale gas and electricity prices, due to fixed-price purchase agreements which are protecting real disposable income and private consumption. The authorities’ efforts to control this sharp increase is the primary reason behind Malta’s lower expected inflation compared to the European average.
Locally, inflation is expected to be significantly higher than 2021 levels, primarily due to higher services and food prices.- Clayton Scicluna
In addition, government intervention in the food market to cap the increase in wheat prices should further minimise the rise in inflation. All components of inflation ‒ services, non-energy industrial goods, and goods, except for energy ‒ are expected to record a sharp pick-up. In fact, a recent survey conducted by the Central Bank of Malta shows that food and services prices are higher than Euro Area average.
The MGSs’ interest rates tend to move with those of other sovereigns in the eurozone. Therefore, the sharp increase in yields for different government stocks in the eurozone has been reflected also in the yields of the MGSs with the inverse related effect on the price.
For illustration purposes and to understand the extent of the increase in yield in layman’s terms, a two-year MGS as at end of June 2022 was giving a yield of 1.22%, which is almost 0.50% more than what a 10-year MGS was giving at the end of 2021. That said, yields are still low when compared to historical measures, but higher than pre-pandemic levels.
Will this rise in yields continue?
In the medium to long term, this is possible; however, in June the ECB held an emergency meeting to discuss the dramatic widening of the euro area peripheral government bond spreads, thus increasing the yields on the government stocks. One may argue that it is beneficial for an investor to have higher yields, but when the speed of the increase is so abrupt, this could have a ripple effect on bond issuers, as this means that now bond issuers must issue their debt at a much higher interest rate, thus a higher interest cost for the issuer.
This could be deterrent to cashflows with a higher likelihood of defaults. Hence, there is the possibility that the European Central Bank will move towards a form of anti-fragmentation tool, with a clear communication on how this will work. If this happens, this will alleviate the rise in yields at least in the short-term, or until such time that the framework remains in force. However, more visibility and guidance on this tool must be provided by the ECB.
One major risk when investing in bonds is usually what investment professionals call the duration risk. Since the interest rates and prices of bonds are inversely related, the higher the maturity and the duration of the bond will result in an even larger drop in price of that bond. Mutual funds investing in fixed income securities can ease some of the drop in the price of the fund by investing in different maturity buckets with a shorter duration.
In addition, by nature, mutual funds are more proactive and will move quickly to take advantage of any opportunities that might arise when the tide starts to turn. These collective investment schemes are structured as open-ended funds that allow investors to enter or exit at the prevailing net asset value per share.
Clayton Scicluna is a portofolio manager at BOV Asset Management Ltd.
The author and BOV have obtained the information contained in this article from sources they believe to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The author and BOV offer no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in the article. They have no obligation to update, modify or amend the article or to otherwise notify readers thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. BOV Asset Management Ltd is licensed to conduct investment services in Malta by the Malta Financial Services Authority.