PETALING JAYA: Malaysia is on the verge of being removed from the World Government Bond Index (WGBI), with local government bonds facing a potential rating downgrade, raising the risk of capital flight and increasing headwinds on the ringgit.
However, bond market pundits told StarBiz that Malaysia’s potential exclusion from the global index could be averted, if the government could address the concerns of index managers and raise market confidence.
Stock market indices provider FTSE Russell has placed Malaysia on the fixed income watch list for at least six months, following the completion of its first fixed-income country classification review.
“Malaysia, currently assigned a ‘2’ and included in the WGBI since 2004, is being considered for a potential downgrade to ‘1’, which would render Malaysia ineligible for inclusion in the WGBI,” said FTSE Russell in a statement yesterday.
FTSE Russell’s move to review Malaysian government bonds’ participation in the WGBI came a week after Norway’s US$1 trillion sovereign wealth fund was told to cut emerging-market government and corporate bonds, which includes Malaysia.
While the decision to add Malaysia on the watch list raises concerns in the domestic bond market, FTSE Russell stressed that it was “not a guarantee of future action”.
This means Malaysia could continue to remain on the WGBI and avoid a downgrade, if the country fulfils the WGBI eligibility criteria at the upcoming review in September 2019.
FTSE Russell also said that it would engage with local regulators and market participants in Malaysia to assess the potential changes to the country’s classification.
“Any WGBI inclusion or exclusion changes resulting from the review (in September), and the timetable for their implementation, would be announced shortly thereafter,” it said.Concerns of a potential downgrade of Malaysian government bonds, among other reasons, weakened the ringgit to RM4.1330 against the US dollar from RM4.1085 on Monday.The benchmark FBM KLCI declined by 0.11% or 1.87 points yesterday, while the trading volume and the value of the stocks traded on Bursa Malaysia fell to the lowest since March 28 due to general lacklustre interest.
In a research note yesterday, Citi Research pointed out that there was a chance for Malaysia to remain on the watch list for more than six months than initially expected.
During this period, discussions are expected to be held between index managers and government authorities.
According to Citi Research, Malaysian Government Securities (MGS) comprised 0.39% of WGBI as of March 2019 and the Government Investment Issues (GII) are not a part of the WGBI.
An estimated tracking of US$2 trillion in passive assets under management (AUM) would translate to an investment of US$7.8bil. For context, this is about 21% of the total foreign ownership of MGS and 8.3% of total outstanding MGS.
Citi Research said Malaysian bonds being in WGBI has been a meaningful source of foreign investment into MGS.
“AUMs tracking WGBI are mostly passive. This makes it unlikely for the investors to pre-empt any potential action by the index managers. Also important to note is that it is highly unlikely for any potential exit from the index to be sudden or disruptive
“On a precautionary note, we scale back our ringgit overlay from 2% to neutral and also scale back the overweight duration on Malaysian bonds to neutral in the emerging market bond portfolio,” stated the research house.
An expert on the Malaysian capital market acknowledged that there would be knee-jerk reaction following the decision by FTSE Russell to put Malaysia on the watch list.
However, he said that any negative reaction from the market would likely be temporary.
“Investors in the Malaysian bond market should not be worried about this unnecessarily. WGBI is not the only bond index provider, there are also others. I just hope the move by FTSE Russell won’t trigger other index providers to move in the same direction. Malaysian bonds are attractive in terms of liquidity,” he said.
In the first three months of 2019, Malaysian bonds enjoyed a strong surge in foreign purchase. The domestic bond market saw an inflow of RM5.1bil in the first quarter of 2019 (1Q19), which has offset equity outflows of RM1.3bil.
In comparison, foreign flows into the Malaysian bonds were only RM400mil in 4Q18.
An economist with a local bank told StarBiz that the government is expected to address FTSE Russell’s concerns during the review period.
“If the government’s response to the index managers is satisfactory, rest assured we would remain on the WGBI.”