Section B Developments in the Domestic Government Bond Market and in Global Bond Markets in 2005

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1 Section B Developments in the Domestic Government Bond Market and in Global Bond Markets in 2005

2 Section B Developments in the Domestic Government Bond Market and in Global Bond Markets in Macro-Economic Developments and Developments in the Domestic Capital Market in 2005 The growth trend in the Israeli economy continued in Gross domestic product (GDP) grew at an average annual rate of 5.2%, versus 4.8% growth in Per-capita GDP increased at a strong rate of 3.4%, versus a 3% increase in the previous year was also marked by inflation within the target range; the Consumer Price Index rose by 2.4%, versus 1.2% in The shekel depreciated against the dollar by 6.8% during the year and appreciated against the euro by 7.3%. Government tax revenues increased in 2005, concurrent with underperformance in ministries' expenditures. As a result, the deficit decreased, to NIS 11.0 billion (deficit excluding net credit granted), or approximately 1.89% of the GDP. In 2004 the deficit stood at NIS 20.1 billion, comprising 3.66% of the GDP. The trend of expanding economic activity resulted from several factors; the key factors are: 1. Continued implementation of a reliable fiscal policy, while effecting structural changes in the economy, streamlining and restraining public spending and reducing the tax burden on individuals and companies. 2. The continued global economic growth trend and the increased volume of international trade, which led to increased demand for Israeli export products. 3. The relative stability in the security situation. In 2005, the Bank of Israel's interest rate rose from 3.7% in January to 4.5% in December, following a decrease in interest rates in 2004, from 4.8% to 3.9%. The interest rate was lowered by 0.2% at the beginning of 2005 and remained at a steady rate of 3.5% for the next eight months; a series of increases occurred in the fourth quarter, reaching a cumulative 1%. The interest rate remained steady over most of the year, due to the attainment of the government's price stability target (an annual rate of 1%-3%), a strict fiscal policy implemented by the government and relatively stable exchange rates. The increases in the interest rate in the fourth quarter resulted from an increase in inflationary expectations, high economic growth rates, depreciation in the shekel-dollar exchange rate, political uncertainty and the rise in the interest rate in the United States. 35

3 Diagram B-1: Developments in interest rates, exchange rates and inflation expectations in 2005 Source: Bank of Israel Against the background of expanding economic activity, the domestic capital market in general and the stock market in particular enjoyed price increases: the General Share Index rose by 30% during 2005, completing an increase of approximately 150% from its low point in February 2003; the TA-25 Index rose by 28%; the TA-75 Index rose by 16%; and the Yeter Index, reflecting the performance of relatively small-cap shares, rose by 25%. Noteworthy among the sectoral indices were shares of commercial banks, which achieved an average return of 45%, and the Tel-Tech Index, which fell by 7% (following an increase of over 150% during the preceding two years). The average daily turnover in shares reached a historical record of approximately one billion NIS, an increase of some 50% compared to the average in Note that trading in the 25 largest shares comprised 64% of total shares traded was marked by a sharp increase in demand for equities from foreign investors, who increased purchase volumes four-fold to a total of $2 billion. At the end of the year, foreign investors held approximately 11% of the equity market versus 10% in the previous year. Bond prices rose at a real rate of approximately 4%, similar to the rate of increase in Daily turnovers in bonds (government and non-government) increased by 40% to a peak of NIS 1.3 billion. Turnovers in corporate bonds rose sharply and were three times higher in 2005 than in the previous year, at NIS 220 million per day on average. The volume 36

4 of funding in corporate bonds also grew impressively, reaching NIS 45 billion, versus NIS 21 billion and just NIS 12 billion in 2004 and 2003, respectively. 2. Main Developments in the Domestic Government Bond Market This year, government bonds again drew the most significant share in volume of trading activity on the TASE, reaching approximately 39% of total trading (excluding the derivatives). Government bond trading volumes continued to expand this year, their daily turnover (on and off the stock exchange) recorded a 26% increase to NIS 1,124 million. A particularly notable increase of 41% occurred in trading volumes of CPI-linked fixed-coupon bonds. Turnovers in unlinked bonds, both fixed-coupon bonds and FRNs (floating-rate notes), increased at a more moderate rate of approximately 25%. Trading in foreign currency-linked bonds stopped almost entirely, as only one small NIS 300 million series remained in circulation. Trading in unlinked fixed-coupon and FRN government bonds comprised 67% of total trading in government bonds on the TASE in Diagram B-2: Turnovers of government bonds on the Tel Aviv Stock Exchange, by linkage type Source: Bank of Israel (A) Unlinked Instruments Fixed Coupon The yield to maturity of Shahar type bonds, which are unlinked and carry a fixed interest rate, decreased during the year. The yield of the 10-Year Shahar 37

5 bond (series 2682) decreased in 2005 from 6.8% to 6.2% and the yield of the 5-Year Shahar bond (series 2680) decreased from 6.4% to 5.9%. Average daily turnovers in unlinked fixed-coupon bonds on the TASE increased by 25% in 2005, reaching NIS 559 million. Diagram B-3: Development of yields of unlinked fixed-coupon government bonds in 2005 Diagram B-4: Yield curves of unlinked fixed-coupon government bonds in

6 Diagram B-4 presents yields of unlinked fixed-coupon bonds at different terms to maturity (hereafter: "yield curves"). A yield curve rising from left to right is the "normal" curve, representing the risk premium investors demand for a long-term investment over a short-term investment. Conversely, a flat curve represents the premium offset against expectations of a decrease in the interest rate. When the market expects the interest rate to rise, long-term bond yields increase relative to short-term bond yields and the slope of the curve steepens. Floating Rate The yield to maturity of Gilon and New Gilon type bonds, which are unlinked and carry a floating interest rate, increased during the year from an average yield of 4.4% in January to an average yield of 5.3% in December. Average daily turnovers in FRNs on the TASE grew by 25% in 2005 to NIS 166 million. The interest on Gilon and New Gilon bonds changes periodically (every six months for the Gilon and every quarter for the New Gilon) based on the weighted average yields of Makams at three months to one year to maturity. This yield is essentially the underlying asset of these bonds; the yield spread at which the bonds are trading is measured relative to the yield of the underlying asset. The difference between the bond yield and the yield of its underlying asset is the "spread." The spread is positive when the bond yield is higher than that of its underlying asset and negative when the bond yield is lower than that of its underlying asset. Note that the Government Debt Management Unit in the Accountant General Division has not issued FRNs since mid Details of the rationale for this policy appear in Section A. (B) CPI-Linked Fixed-Coupon Instruments The real yield to maturity of Galil type bonds, which are linked to the Consumer Price Index and carry a fixed interest rate, increased moderately during the year, from an average annual yield of 3.5% in January to an average annual yield of 3.6% in December. The average daily turnover in CPI-linked bonds on the TASE grew by 41% in 2005 to NIS million. 39

7 Diagram B-5: Development of yields of CPI-linked government bonds in 2005 Diagram B-6: Yield curves of CPI-linked government bonds in

8 3. Developments in the Global Bond Market (A) Interest Rate Environment Medium and long-term interest rates remained quite low in U.S. and European bond markets during 2005, as in Yields of U.S. government 10-year bonds ranged from 3.88% at their low point in early June to 4.66% in early November. In Europe, the yield of 10-year German government bonds (the most liquid government bond, which serves as a benchmark for bonds in the euro bloc) decreased from 3.78% in mid-march to 3.024% in late September. Diagram B-7: Developments in yields of U.S. government bonds at 5 and 10 years to maturity, In the United States, the Federal Reserve continued to raise the basic interest rate steadily in 2005, from 2.25% at the beginning of the year to 4.25% by December. The increase in the basic interest rate did not cause the expected significant increase in medium and long-term interest rates; as a result, the U.S. interest rate curve flattened. The short-term dollar LIBOR interest rate also rose significantly, from 2.78% at the beginning of the year to 4.7% at its end, while the U.S. swap curve flattened, inter alia due to expectations of a future slowdown in growth in the U.S. 41

9 Diagram B-8: Developments in the three and six month LIBOR interest rate in (B) Foreign Currency Market In the foreign currency market, the dollar resumed gaining strength against the euro, with the exchange rate falling from the peak level of $1.36 per euro at the beginning of the year to $1.185 per euro by the end of the year. The strengthening resulted from the continued strong growth in the United States as compared to Europe, among other factors. The yen weakened considerably against the dollar during the year, from 102 per dollar at the beginning of 2005 to approximately 120 per dollar at the end of the year. 42

10 Diagram B-9: Developments in dollar exchange rates against the Japanese yen, the euro and the GBP in (C) Sovereign Bond Issues In 2005, the global bond market was marked by issues with exceptionally long terms to maturity due to three main factors: (A) The interest rate environment which remained quite low in historical terms; (B) The flattening of the yield curve; (C) Rising demand for long-term bonds from pension funds which were required to adjust the terms to maturity of their assets in order to match their liabilities. Issuers, on their part, focused on long-term debt out of a desire to establish low long-term interest rates and take advantage of the brisk demand for long-term instruments in order to reduce refinancing risk. In line with these trends, exceptionally long-term debt was issued by the French government (50 years, denominated in euro) and by the UK government (two 50-year issues, denominated in GBP, one CPI-linked and the other at a fixed interest rate) in Long-term debt at a term to maturity of 30 years was also issued in 2005, by Spain, Greece, Italy and Holland, as well as the U.S. government, which resumed issues at this term to maturity after a five-year hiatus. Countries with a lower credit rating also issued bonds this year at longer terms to maturity than usual in those countries. Thus, for example, Brazil issued a 30-year dollar-denominated bond, Turkey issued a 20-year dollardenominated bond and a 12-year euro-denominated bond and Israel also issued its longest-term euro-denominated bond at a 10-year term to maturity. 43

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