An analysis on the duration risk and its sensitivity on the local bond market

Abstract

Theory states that the directional effect of a fluctuation in interest rates would be that: When market interest rates rise, the price of bonds declines. Rationale: Newly issued bonds would offer a higher yield than previously existing securities. As a result the ‘older’ bonds would be worth less and their price goes down. Conversely, when market interest rates decline, the price of bonds rises. Rationale: Newly issued bonds would offer lower yields than older securities making the existing securities with higher yields worth more. This results in a price decline. The main objective of this study is to carry out a descriptive analysis on the interest rate sensitivity of the local bond market. An empirical study, sub-divided into qualitative and quantitative research methodologies was carried out to evaluate the behaviour of the local bond market and ascertain with sound observation whether such behaviour conforms with the theoretical expectation of interest rate risk and its relationship with the principles of duration. The overall research results provided substantial evidence that the Maltese bond market is predominantly unique through its distinct behavioural characteristics. This was proven through the inconsistent duration results and interview findings. Results also showed that the market for local sovereign bonds is highly interest rate sensitive whilst the market for local corporate bonds is considerably unresponsive to fluctuations in interest rates. This means that the corporate bonds in comparison to the government bonds do not behave in an expected manner.