The bond markets across the euro area remained particularly volatile in recent weeks as the ongoing developments in the Middle East are leading to wild swings in the oil price, which directly feeds into inflation expectations.
Fixed income (bonds) as an asset class is generally regarded as one that is ideal for cautious investors in view of the low risk nature of a bond instrument. However, the persistent volatility in yields, and naturally in bond prices, may be concerning for many Maltese retail investors. This is particularly important given the current issuance of a maximum of €500 million in Malta Government Stock (MGS) issues.
Oil price and bond yields
The instability across the energy sector, which impacts inflation expectations, is leading to constant volatility in sovereign bond yields.
The price of oil, measured via Brent crude, jumped from around $70 a barrel before the intense geopolitical tensions and outbreaks of war in the Middle East to above $110 a barrel in April as hostilities intensified, culminating in the closure of the Strait of Hormuz. On the news of the agreed ceasefire between the US and Iran, Brent retreated back towards the mid-$70s but this has proved short-lived.
A renewed exchange of strikes in recent days, and warnings of a wider confrontation, sent the oil price back up towards one-month highs of above $90 a barrel. The price of Brent crude remains highly sensitive to daily developments around the Strait of Hormuz.
Germany’s 10-year Bund yield, which is considered as the risk-free benchmark for the euro area, climbed from roughly 2.65% before the start of the conflict to around 3.10% by late March. After easing back towards the 2.85% level for a brief period during the ceasefire, the 10-year yield jumped back up in recent days to 3.15%, its highest since May 20.
Throughout this period, the European Central Bank (ECB) has, as the market anticipated, delivered its first interest rate increase in over two years in mid-June as it hiked its deposit rate by 25 basis points to 2.25%. ECB policymakers had been signalling that the upside risks to inflation from the energy shocks were serious enough to warrant action even at the cost of near-term growth.
The latest inflation data across the euro area published last week shows that headline inflation eased to 2.8% in the year to June, down from 3.2% in May and below the 3.0% expected. Core inflation fell back to 2.4%, and second-quarter inflation averaged 3.0% against the ECB’s forecast of 3.2%, reflecting the lower energy prices during the short ceasefire. Although the lower inflation reading is welcome news, the improvement was clearly driven by the energy component that has since turned higher again in view of the renewed escalation in the Middle East.
The ECB’s monetary policy meeting is taking place this week at the time of the planned MGS issuance with natural implications on the pricing dynamics by
institutional investors. Traders across the international fixed-income markets are again adjusting to a “higher-for-longer” inflationary environment due to the persistent geopolitical conflict involving the US and Iran.
Movements in the MGS market
The daily indicative MGS bid prices quoted by the Central Bank of Malta mirror closely the movements across the eurozone benchmarks. MGS yields have therefore been very volatile as the 10-year yield rose from 3.53% in late February to above 4.05% by the end of March. It had then drifted towards 3.70% at the time of the ceasefire and currently hovers around 4.00%.
This is reflected in the indicative price of the 3.80% MGS 2036 (III) that was issued earlier this year. The price had dropped to a low of 97.92% in mid-May compared to the fixed offer price to retail investors of 100% par value. It had then completely recovered to 100.83% at the end of June before dropping back to below 99% earlier this week.
A new 20-year MGS
The issuance of a 20-year bond is an important feature of the new offering. Apart from the 20-year bonds with a coupon of 4.25%, there will also be another 10-year issue again at 3.8%.
Although the Treasury Department has issued 20-year bonds before, and the longest dated bond is currently 26 years (maturing in 2052), the ability of the Treasury to place these 20-year bonds in this environment will provide important pointers of the structural shifts taking place across the MGS market, as I highlighted in one of my articles in April.
The results of the last MGS issuance earlier this year clearly demonstrated that the appetite for long-dated Maltese sovereign bonds (beyond 10 years) is increasingly contingent on international institutional demand.
European credit institutions were allotted €228 million in the MGS issue in April, representing 78.6% of the competitive auction and circa 46% of the entire issue of just under €500 million.
Meanwhile, for Maltese retail investors who generally focus on the coupon being offered (in this case it is 4.25%) rather than the term to maturity, these long-dated bonds carry increased price risks that warrant attention.
A 20-year bond price has substantially greater interest rate sensitivity, which is particularly important for investors who may need to sell their holding before maturity. These investors would be exposing themselves to meaningful capital risk should yields be higher than current levels when they would need to sell the bond.
Movements in MGS prices in recent years provide ample evidence to investors on the volatility in prices. As interest rates jumped sharply in 2022 and 2023, the prices of all MGSs declined, with the largest movements across the long-dated bonds. Likewise, as interest rates decline, long-term bond prices rise.
On the other hand, for those investors who purely intend to collect annual coupons and receive par at maturity (so-called ‘buy-and-hold’ investors), this 20-year MGS, with an interest rate of 4.25%, is the highest yielding sovereign offering in three years and should attract a number of retail persons who continue to invariably maintain far too much idle liquidity across the banking system that is not generating any sort of returns.
Any investors considering these new MGS offerings need to first determine their possible investment horizon since this matters a great deal. Matching the maturity of a bond to one’s actual investment horizon – and laddering across maturities rather than reaching for the longest bond simply because it offers the highest yield – is a very important factor that investors need to contemplate when deliberating these MGS issues, and also others in the near term, as the Treasury requires record issuance in excess of €1.9 billion this year.
Edward Rizzo is executive director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.
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