Dangers of rising bond yields

THE great run that the bond market enjoyed for more than 15 years has ended.

All over the world, bonds are being sold which has caused the yields of debt papers to shoot up.

To the uninitiated, bond prices move inversely with yields. When price comes down, the yields on debt papers go up. The reverse happens when bond prices go up.

Malaysian government debt papers are no exceptions. The yield on 10-year Malaysian Government Securities was 3.663% a month ago. In October, the yield was only 3.579%.

Now the yield is at 4.128% – a difference of almost 47 basis points if compared to a month ago and 55 basis points if we consider the movement from October.

In the world of the bond market where dealers talk in millions and billions, a change of even 10 basis points in a month is huge. Here we are talking about a change of five times more.

What does that mean for the average Malaysian?

Rising bond yields have both positive and negative effects on the economy.

The most damaging for a country like Malaysia is that rising bond yields will eventually translate to higher cost of borrowings. Not only the government, even corporations and households will face a higher cost of borrowing.

Rising yields means the risk premium is higher. Lenders would demand higher rates for loans. The trickle down effect would be bad for Malaysia, which is still in the midst of restructuring its economy in the wake of the collapse in oil prices.

Money from oil drove the economy for many years. Unfettered spending without setting aside some financial resources for rainy days was the policy adopted by decision makers to keep the economy moving.

Today we pay the price. Everybody – right from the civil servants to the private sector – is being told to cut cost and tighten the belt.

A rising interest rate environment is surely bad for the property sector that has already slowed down.

Beyond that, a higher cost of funds affects expansion of companies and investment decisions. This in turn will impact earnings and dividends.

So if yields of Malaysian government debt papers continue to spiral, it would not bode well for the stock market.

The trend of inverse relation between rising yields and falling stock market is not evident in Bursa Malaysia. However it is quite clear if one were to look at the performance of Dow Jones Industrial Index and US dollar 10-year papers over the 20 year period.

Among the positives is that rising bond yields would force banks to offer higher deposit rates.

This is something that would be welcomed by pensioners and pension mutual funds who have been suffering due to the long period of ultra low interest rate environment.

More importantly, rising bond yields will also bring back some kind of normalcy in the financial markets of emerging countries that have been complacent living with “cheap money”.

It will bring about a new term of reference when countries, companies and individuals borrow. Hopefully it would end the addition to debt that has caught on in most emerging markets.

Governments will be forced to pay more for taking on debts. Hopefully it would force them to realise every bond issued or guaranteed is going to cost more.

The same goes to companies and individuals who have in the past eight years expanded their balance sheet with the comfort of that the cost of funds is cheap.

Apart from pensioners, banks should benefit with a higher cost of funds as it should help financial institutions price loans more competitively.

In the past, banks used to compete to grow their loans book. One way was to offer “cheap” housing loans to eligible customers. Schemes such as offering loans below the base lending rate for the first five years were common.

Obviously banks were losing money in the first five years. But they needed to grow the business and such give-aways were common. That would end when bond yields, which has an impact on the interest rate, rise.

On a broader scope, rising bond yields indicate that the markets are confident that the economies of developed countries are likely to grow again.

Since 2008, the US had adopted an ultra low interest rate policy of almost 0% to revive its battered economy. After the US, Europe, the UK and Japan all have adopted an ultra loose monetary policies to lift their economies.

Now the US is raising interest rates again to calm inflationary pressures there. There is a strong likelihood of the Federal Reserve raising interest rates when it meets next week.

For months the indicators have pointed to the US raising rates by another 25 basis points from its current band of 0.25% to 0.5%.

The plans of President-elect Donald Trump to inflate the US economy with a US$1 trillion fiscal stimulus has accentuated the view that the interest rates will rise in the US this month and going into next year.

The reason is that the stimulus exercise is expected to trigger a big demand in the US for everything – from labour to capital – hence causing inflationary pressures.

There are signs that other regions are likely to follow the US example and stop the era of maintaining a cheap money policy. In this respect European Central Bank has also said it would reduce its bond-buying programme, a measure adopted to inflate the eurozone economy.

The rising bond yields in the US and other parts of the world all point to a rising interest rate environment.

While it is healthy for rates to rise in developed markets, it is not so good for a country like Malaysia where the government and households are mired in debt.

But there is very little that can be done to reverse the trend.