(ATF) Index provider FTSE Russell announced on March 30 this year that Malaysia will be removed from its negative watch list and will retain its membership in the FTSE World Government Bond Index (WGBI).
FTSE noted that the Central Bank of Malaysia has made significant progress in improving secondary market liquidity through the re-opening of Malaysian Government Securities (MGS) issuance, introducing MGS futures, and making more MGS available via repo.
It has also enhanced the foreign exchange market structure through increased price transparency after local trading hours and expanded the dynamic hedging program to include Japanese trust banks.
Why is this important?
The removal of Malaysia from the watch list is a significant development and a catalyst for a tactical rally, with 10-year Malaysian rates poised to come off by 30-40 basis points. This is because, having remained on FTSE Russell’s negative watch list for so long – almost two years since April 2019 – may have contributed to chronic negative sentiment and investors being underweight on Malaysian bonds.
However, several entrenched fundamental challenges remain.
Possible change of government
The Malaysia bond market is still confronting slow fiscal normalisation amid fractious politics. The current administration is surviving by imposing “pandemic-emergency conditions” which preclude meetings of Parliament. Emergency conditions are likely to end by late in the third quarter, with a mid-term election and possible government change likely by the last quarter of 2021.
Pending the formation of a new government and passing of a new budget, unsettled local politics will extend fiscal uncertainty into 2022. What’s more, the allowance of pension withdrawals by pandemic-stricken residents since the end of last year amounts to below-the-line fiscal easing, which has hampered the country’s main pension fund’s ability to continue absorbing large amounts of local government bonds.
From a fixed income standpoint, the two key questions worth revisiting are:
1) How much of the accumulated political and fiscal setbacks and downgrade risks are already captured in the price of Malaysian local bonds?
And 2) Can the improving external backdrop become a tailwind for the bonds?
The answer to the first question is that a lot of bad news is already in the price.
The term-premium for Malaysia’s bond yield curve is at its steepest in a decade. This reflects elevated supply risk rather than a dire inflation outlook. Inflation is currently negative but is expected to rise this year to around 1.8%, according to the Bloomberg survey median. Amid such bleak – or, depending on perspective, attractive – valuation, the alleviation of bond index exclusion risk becomes an important catalyst for a near-term rally.
This brings us to the second question: Can the improving external backdrop help Malaysian bonds?
Cheap entry point
For now, global demand recovery, firming commodity prices and ongoing FX intervention are providing a cheap entry point into Malaysian bonds.
Malaysian exports are picking up and monthly trade surpluses have been surprisingly on the upside. In comparison with other exporters, Malaysian exports have been rising at the second fastest rate in East Asia (ex-China), after Taiwan, amid the global recovery.
In conclusion, the removal from FTSE Russell’s negative watch list doesn’t solve Malaysia’s fundamental problems, though by alleviating index exclusion risk it will re-focus investor attention to the attractive valuations at hand in the Malaysian government securities market.
From a valuation-fundamental-technical backdrop, we believe Malaysian bonds now tick solid valuations and firm technicals. Where there are challenges on the fundamental side, an externally driven balance of payments (and growth) adjustment is underway.
Meanwhile, ongoing foreign exchange intervention provides a relatively cheap Malaysian ringgit environment in which to accumulate attractively valued local bonds.