Ireland will feel the pain of any steep rise in bond yields
Irish bond yields climbed back above 1pc last week. With the Irish state still owing €200bn, will higher bond yields derail our economic recovery?
Bond yields matter, with a lot with medium and long-term rates being largely determined by the international bond markets. Ireland has benefited enormously from falling bond yields, with the yield on our 10-year bonds falling to just 0.37pc in August - bond prices and yields are inversely related, with yields falling when prices rise and vice versa.
Last week, Irish 10-year bond yields rose back over 1pc for the first time since January. Ireland's general government debts now stands at €200bn. Servicing this debt mountain, even at low yields, is expensive: the Department of Finance forecasts interest costs of €6.3bn in 2017. Interest costs will gobble up an eighth of 2017 tax revenues. Even a 1pc increase in the average interest rate would cost the exchequer an extra €2.1bn a year.
Higher bond yields, and the higher interest rates that would come in their wake, would also hit the banks, who still have huge volumes of problem loans on their balance sheets. At the end of June, 17pc of AIB's loan book and 12pc of Bank of Ireland's were categorised as impaired.
But rising bond yields aren't all bad news - at least not yet.
"We had ridiculously low 10-year bond yields. We still have exceptionally low bond yields," says Ibec director of policy Fergal O'Brien, who believes that the Government should take advantage of low bond yields to invest in our infrastructure.
"We feel real frustration that the Government is not taking advantage of this cheap money while we can," he said. "The EU is calling for an end to austerity. This is a golden opportunity to improve the quality of life of our people and increase the growth potential of the economy."
While bond yields have risen from last August's exceptionally low levels, this is unlikely to feed through into the cost of servicing any Government debt just yet. The National Treasury Management Agency has locked in the cost of most of Ireland's borrowings several years out. The projected €6.3bn 2017 interest bill works out at an average interest rate of 3.1pc. The Department of Finance is predicting that the average interest rate will fall slightly to 3.04pc in 2018 and to 2.84pc in 2019.
But what about the banks? On Thursday, the Department of Finance restarted the process to sell some of the state's 99.8pc AIB shareholding.
We have been here before: Michael Noonan was forced to abandon a sale this year, following the collapse in European bank shares.
Will the rise in bond yields scupper the Finance Minister's plans once again? Not necessarily.
When it comes to ultra-low bond yields and interest rates, it turns out that banks can get too much of a good thing.
Extremely low interest rates make it very difficult for banks to make a profit, as the traditional banking model of taking in deposits from depositors and lending them on to borrowers at a margin breaks down. "Banks typically benefit when rates rise," says Davy Stockbrokers' banking analyst Emer Lang. "On balance it [the rise in bond yields] should be positive." One clear beneficiary of a rise in bond yields will be pension funds, including the banks' own employee pension funds. Actuaries use bond yields to value future pension liabilities, with higher yields translating into lower present values of future pension liabilities.
Lang reckons that the recent sharp rise in bond yields has largely reversed the €250m third- quarter increase in Bank of Ireland's pension fund deficit. A modest rise in bond yields and interest rates would pass largely unnoticed. But will it?
Last week, Fed chairwoman Janet Yellen sent the strongest signal yet that she is getting ready to hike US rates when she told a Congressional Committee that the Fed could raise rates "relatively soon".
President-elect Donald Trump's promise of tax cuts and $1 trillion of infrastructure spending will incline Yellen to further rate increases. Meanwhile, the ECB's bond-buying programme is due to end next March. This means that the increase in bond yields could be much greater and take place much more quickly than had been expected.
If this happens, then we in Ireland will quickly feel the pain.
Sunday Indo Business