Of recent times, a lot of interest has been expressed in the bond market. It is becoming vogue. Indeed, the last bond auction saw, for the first time since 2003, bonds in the primary market being picked up at a premium. The issue was of course oversubscribed and yields on the bonds were lower. See tables below.

Source: CBK

Indeed, all government paper yields across maturity profiles have trended downwards through-out 2009. The interesting thing about the downward movement of yields is that it has been replicated in a lot of major markets including the EU, the UK and the US amongst others.

The low interest rates point to an increase of loanable funds versus a fixed supply of demand for loanable funds. In an economy that is showing anaemic growth, one would ask, where does the increase in loanable funds come from taking into account the weak growth? Shouldn’t it be that when the economy shrunk, as the Kenyan economy did between Q209 and Q309, money supply should have shrunk with it too?

The answer lies broadly from two occurrences. The first is interest rate arbitrage from foreign investors. In a lot of developed countries such as Japan, the Unites States, the United Kingdom as well as Europe and parts of Asia, interest rates are on record lows. In search of higher yields, Kenya becomes an attractive investment destination. For example, in the United States, the interest rates for the short term US treasuries is between 0%-0.25% compared to the short term interest rates for similar Kenyan paper which is between 6.5%-7%. One can arbitrage from the differential in interest rates and the movement of currency by borrowing from the US and investing in Kenya. Further, currency movements are likely to favor Kenya in the short term because of the high nominal interest rates prevailing in the Kenyan economy and at the same time the improvement of prices of bonds due to the downward trend of interest rates which serve to improve the value of the investments.

The second is due to the activities of the Central Bank of Kenya. As can be seen in the diagram below which captures movement in interbank trading. The Central Bank has been trying to hold down the interest rates through use of quantitative easing and this is evident in the movement of the red line (interest rates) that show a tendency to rise only to sharply drop down again.

Source: CBK

Both occurrences can be seen as the impact of Central Banking policies both at the international and at local levels. Once one understands this, it can be easier to discern what direction these policies shall push the bond market.

First and foremost, it is important to appreciate that these policies are not sustainable. The expansionary policies being implemented by both central banks, sooner or later, are going to lead to higher interest rates. This is likely to be preceded by development of asset bubbles and thereafter price inflation. The twin risks of higher inflation and economic slowdown (when the two events occur concurrently the phenomenon is known as stagflation) will lead to higher costs of borrowing thus destroying value of bonds.

Already, as it is, the price of oil is approaching USD 100/BBL and the prices of other commodities, such as gold, are on the rise. The prices of stocks around the world have trended upwards despite the flat or shrinking world economies.

Which brings up the question, what kind of bonds should investors be seeking? Short term paper reduces risk of capital loss and the short term trends of dipping interest rates may offer capital growth and at the same time fixed income. Long term papers on the other hand could be hurt by high inflation through increases in market rates that could translate to a capital loss and lower purchasing power on earnings from the bonds. If one is in the bond market, therefore, this is the time to go for the short end of the curve.

Source: The KenyanRepublican (http://kenyanrepublican.blogspot.com)