Roadblocks loom for best-performing Malaysian bonds

Bank Negara Malaysia’s interest rate cuts have been the main driver for the rally in Malaysian bonds.

KUALA LUMPUR: The rally that has made Malaysian bonds the best performers in Asia this quarter is starting to sputter.

Challenges threatening to snuff out gains includes faltering demand at recent debt auctions, diminishing expectations for another interest-rate cut, concern about possible exclusion from a key global bond index, and the prospect of another bout of political uncertainty.

“We expect bond yields to have seen their lows this year,” though supply-demand dynamics should prevent them from rising too far next quarter, Jennifer Kusuma, senior rates strategist at Australia & New Zealand Banking Group Ltd in Singapore, wrote in a research note.

“Malaysia’s political backdrop has also proven to be unstable this year and could raise uncertainties around policy continuity,” she said.

Fading interest

One of the most obvious warning signs is declining demand at the government’s conventional bond auctions. The bid-to-cover ratio fell to 1.47 times at a sale on Aug 13, the lowest this year, and was only a fraction higher at 1.54 times on Sept 3.

The average of the previous 11 conventional offerings was 2.16. A sale of five-year debt later this month now looms as a key test of investor demand.

Malaysian bonds have easily outperformed the rest of Asia this quarter. A Bloomberg Barclays index of total returns from the securities has risen 6.2% since the end of June, well ahead of second-placed China, which has risen 3.5%.

The nation’s benchmark 10-year bond yield has dropped about 20 basis points (bps) over the period to 2.64%.

The main driver of the rally has been expectations the central bank will keep cutting interest rates to combat the impact of Covid-19. Now that policymakers have already trimmed their benchmark by a combined 125 bps this year to a record-low 1.75%, markets are starting to doubt there is much room left.

Ringgit swaps indicate the key rate will stay at the current level for the next 12 months, after earlier pricing in at least part of an additional cut as recently as August.

Immediate risk

The most immediate risk to Malaysian bonds appears to be the next country classification review of its indexes by FTSE Russell due on Sept 24. Malaysia has been on a watch list for possible exclusion from the World Government Bond Index due to accessibility factors since April 2019. If the country is removed from the gauge this may potentially lead to outflows from index-following funds.

“Fixed-income security investors are generally positioned defensively ahead of the FTSE Russell decision, with a modest relief rally expected in the event Malaysian bonds are removed from the watch list,” said Winson Phoon, head of fixed-income research at Maybank Kim Eng Securities in Singapore.

Even if Malaysia escapes the FTSE Russell review unscathed, there are plenty of other reasons to think the bumper rally they have enjoyed over the past three months may be drawing to an end.

What to watch

The Philippines will publish balance-of-payments figures on Monday, and auction 10-year bonds the following day.

The Bank of Thailand will hold a policy meeting on Wednesday, the last to be led by outgoing governor Veerathai Santiprabhob. Thailand will release customs trade data the same day.

Malaysia’s August inflation numbers are due on Wednesday, with the nation having experienced deflation in the previous five months.

Marcus Wong is an EM macro strategist who writes for Bloomberg. The observations he makes are his own and not intended as investment advice.