Malaysian bonds losing momentum

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

Challenges threatening to erase gains include weaker demand at debt auctions, lower expectations for another interest-rate cut, concern about possible exclusion from a key global bond index, and the prospect of renewed 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 ANZ Banking Group 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.”

One of the most obvious warning signs is declining demand at government bond auctions. The bid-to-cover ratio fell to 1.47 times at a sale on Aug 13, the lowest this year, and was just 1.54 times on Sept 3. The average of the previous 11 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-place China, up 3.5%. Malaysia’s benchmark 10-year bond yield is down about 20 basis points in the period to 2.64%.

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

Ringgit swaps indicate that 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.

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

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