Slowdown in bonds: A number of factors are weakening appetite for debt

Bond issuance in Malaysia has slowed considerably in recent months. The growth rate in government bonds outstanding went from the high double digits before early 2013 to single digits and negative after. The total had grown more than 10% year-on-year between February 2010 and February 2013, hitting a high of 31.1% in February 2012. Growth went negative between September 2013 and January 2014.

The situation in the corporate bond market has been much the same. The rate of growth year-on-year was above 10% almost every month between June 2011 and May 2013. After that, the rate went to single digits, according to data published by the Asian Development Bank’s Asian Bonds Online. In March 2014 corporate loans outstanding were up 7.46% from March 2013.

Slowdown

The reasons for the slowdown are many. Partly, it is due to the rise in interest rates in the US, the tapering in the Federal Reserve’s quantitative easing (QE) programme and expectations for faster economic growth and still higher rates in the US. Malaysia was relatively attractive to foreign investors because of its high interest rates, but as the dollar debt markets started to look relatively strong, investors started to shift their holdings away from the ringgit. Between May 2013 and December 2013, the 10-year US Treasury bond went from 1.63% to 3.03%. Malaysia’s 10-year government debt traded between 3.5% and 4.2% during that time, with the spreads narrowing with US Treasuries to the point that some investors did not feel as though the extra return justified the higher risk. The ringgit also weakened considerably from 2013, hitting a low of 3.34 to the dollar in early 2014, further weakening the case for investing in Malaysian bonds.

The reduced interest on the part of foreign investors comes through clearly in the numbers. In March 2013 foreigners held a total of 31.6% of Malaysian local currency government bonds, an all-time high and up from 0.16% in June 2001, according the Asian Bonds Online. But since early 2013, foreign interest has dropped. It hit a recent low of 28.24% in September 2013. While it rebounded to 29.4% in December 2013, it remained significantly below its previous peak.

No Need 

Domestic Malaysian corporations, flush with cash, are also tapping the bond market less. The banks are competing heavily for loans, so much so that it often makes more sense for Malaysian corporations to simply borrow from these institutions when they need funds. The average lending rate, for example, dropped from 4.89% in August 2011 to 4.47% in May 2014.

Other factors are at work as well. The government is hitting its self-imposed ceiling on sovereign borrowing, and that is making it more difficult for it to issue paper. At the end of 2013, the government debt-to-GDP ratio was at 53.8%, just below the cap of 55%.

Malaysia has promoted its bond market heavily in order to give its corporations access to the type of capital that will allow them to better withstand economic shocks. During the 1997-98 Asian financial crisis Malaysia was too dependent on short-term borrowings, and much of it was dollar-denominated, so the government started building a bond market in earnest after the collapse. In a very short time, it had the largest local currency bond market in ASEAN. As a result, however, Malaysia is now highly dependent upon the international markets. With a third of the local currency bonds controlled by foreigners, the second-highest ratio in ASEAN after Indonesia, the country is greatly exposed to interest rate movements in the West.

Promising Signs

A number of forces, trends and events suggest that the rush away from bonds may be temporary and that the market will remain stable even in the event of serious external shocks. Domestic interest rates, for example, are bound to rise. While the central bank has held its overnight policy rate steady at 3% since 2011, inflation is starting to increase and it is expected that rates could begin to creep up later in 2014 or early 2015. Any moves in this respect may make Malaysian bonds more attractive and draw money back into the country’s debt markets. On the other hand, the rise is the rates in the US could slow and QE could be held steady if it seems that economic conditions in the US or internationally are deteriorating once again.

Rate Gap

In early 2014 it appeared that the interest rate gap with the US was beginning to work in Malaysia’s favour. A strengthening of the ringgit and a decline of rates in the US resulted in money flooding in from overseas back into bonds, bringing a quick end to the run for the exits that that had been in the making earlier. Foreign holdings in government and corporate bonds hit a record RM249.5bn ($77.87bn) during that month. In early July 2014 there were expectations that high rates in Malaysia could contribute to more inflows into the local currency bond market. Easy money in the EU, China and Japan may help support inflows as well. It is also of note that simple maths will take some of the pressure off and allow for growth in the bond market. As GDP rises, more debt can be issued and the country can in part grow its way out of the problem.

The government is also taking some action. In June 2014 Prime Minister Najib Razak said that a number of key reforms would be undertaken. Foreign investors would be allowed to own local unit trust companies, removing all barriers to entry in this sector. Perhaps more directly relevant to the bond market, from 2017 corporate bond issuers will no longer be required to get credit ratings and foreign rating agencies will be able to operate within the country without a local partner.

The reason for the reforms is ostensibly to help Malaysia reach its goal of becoming a developed economy by 2020, but they will also help to stimulate the bond market in the near term. Companies will able to go to market without waiting for a rating, while a more competitive ratings market might in itself stimulate demand. “Malaysia needs to work on developing its own credit culture,” Teng Chee Wai, the executive director of Hwang Investment Management, told OBG. “Unrated paper should be allowed to come to the marketplace and investors need to be educated so they can make their own assessments when it comes to evaluating the creditworthiness of domestic securities.”

The Goods and Services Tax (GST) might also help the country’s bonds. The GST, which has been in discussion for about five years, is set to come into effect on January 1, 2015. The rate will be 6%, with a list of zero-rated goods. While the tax is highly controversial, it is seen helping the fiscal deficit and lowering the income tax. It will also help the country maintain its credit rating and overall boost the outlook for the country’s bonds. When Fitch cut the credit outlook for Malaysian bonds to negative in July 2013 due to budget problems, bonds rallied in part on the hope that the GST would be put into effect because of the cut.

Debt Ceiling

It is also possible that money will be flowing into the corporate bond market for government-guaranteed issuers. Because the government is reaching its self-imposed debt ceiling, funds are being raised through companies that are backed by the country’s sovereign rating. These bonds are proving somewhat controversial because they are seen as off-balance-sheet liabilities of the government and, according to some calculations, bring the total national debt to GDP level to 70%. Opposition politicians claim that these liabilities are a danger to the economy and are part of the reason for Fitch’s negative outlook.

With the Economic Transformation Programme under way, it is likely that the corporate bond market will grow even as the sale of government bonds is limited. Infrastructure projects will in part be funded through corporate bonds that will have a government guarantee, and this will lead to an increase in corporate bonds outstanding, with pure national debt remaining capped by the limit. Four of the top five issuers of local currency bonds are state-owned, while the top issuer of local currency debt has significant government support, according to the Malaysian Rating Corporation.

Ultimately, however, Malaysia will reach a point where it will become difficult to shift national liabilities to corporate balance sheets. The rating agencies have highlighted this as a potential problem, and if the accounting trick continues to be used it could cause a downgrade of the country’s rating and further slow the market.