The Tapering Anxiety - MARC

January 13, 2014 www.marc.com.my

2014 Bond Market Outlook

The Tapering Anxiety

Fixed Income Research KDN PP 16084/10/2012 (030859)

MALAYSIAN RATING CORPORATION BERHAD (364803 V)

Economic and Fixed Income Research Department

Nick Lee Chin Fah Afiq Akmal Mohamad Fixed Income Analyst Economic Analyst [email protected] [email protected]

Nor Zahidi Alias Nurhisham Hussein Chief Economist Economist [email protected] [email protected]

mailto:[email protected]





MARC Fixed Income Research www.marc.com.my 2

Executive Summary

Remarks by the United States (US) Federal Reserve’s (Fed) Chairman on the possibility of a

tapering in bond purchases since May 2013 and the decision to scale back in December Federal

Open Market Committee (FOMC) meeting have pushed up US Treasury (UST) yields significantly. In

response, global sovereign bond yields also spiked up as anticipations of a reduction in bond purchases

heightened. Yields of the benchmark 10-year UST note surged to around 3% level by end of December,

compared with its recent trough of 1.63% in May 2013. Going forward, we foresee bond purchases to be

trimmed at a measured pace by the Fed due to (1) the inflation rate as measured by personal consumption

expenditure price index (PCE) of 0.9% in November, which is well below the Fed‟s target of 2.0% and is

expected to remain benign in the foreseeable future, giving flexibility to the Fed to maintain some degree of

stimulus to further support the economic recovery; (2) the US housing sector which may be threatened if

interest rates were to rise rapidly; (3) the “dovish” remarks by Janet Yellen, the incoming chairwoman of the

Fed who showed strong support for Quantitative Easing (QE) 3 by stating that asset purchases are needed

to promote a more robust economy and a reduction of the stimulus policy can only be undertaken when the

US economy and labour market show sustainable improvements.

The euro zone economy will continue to expand at a sub-par level with some downside risks and

hence German Bunds will likely outperform the UST. Deflationary risk and a nascent economic

recovery will likely induce the European Central Bank (ECB) to maintain the benchmark refinancing rate at

a record low of 0.25% for the foreseeable future. In addition, the ECB may unveil additional long-term

refinancing operations in light of rising money market rates and the strong euro which could slow down the

pace of economic recovery. With the expectation of the ECB maintaining near-zero interest rates and a

tepid recovery in the euro zone economy coupled with the tapering plan by the Fed, German Bunds should

continue to outperform UST with yield spreads continuing to widen in the year ahead.

In the United Kingdom (UK), Gilts will closely track the performance of the UST as the UK economy

continues to outperform other European economies judging by latest data releases especially on

the labour market and housing sector performances. The Bank of England‟s (BoE) latest forecast of a

more rapid decline in the unemployment rate to the 7% threshold by mid-2015 rather than by late 2016

could mean that the central bank may tighten its monetary policy earlier than expected. In addition, a strong

correlation between the US and the UK financial market leaves UK Gilts open to risks of tapering by the

Fed. All in all, we see UK sovereign bond yields to trend upward by almost a similar pace as UST in 2014.

Malaysia’s relatively open financial market means the Fed’s tapering will add to the volatility of the

ringgit and the bond market. This is evidenced by the local currency market where the ringgit has been

sensitive to the Fed‟s tapering plan, weakening by as much as 8.3% to RM3.33 against the USD in August

as foreign investors trimmed their holdings of Malaysian Government Securities (MGS), leading to the

biggest loss since 2008. In addition, the responsiveness of Malaysia‟s Credit Default Swap (CDS) market to

external news implies that investors would continue to keep an eye on developments related to the Fed‟s

monetary stance.

Narrowing yield spreads with sovereign bonds of advanced economies will slightly dampen the

demand for MGS. Given rising yields in the major developed countries, sovereign yield spreads of MGS

against other major sovereign bonds are narrowing, reducing investor appetite for MGS as they shift their

interest to major sovereign bonds which are now offering rising yields. Compared to the widest sovereign

spread of 173 basis points (bps) between the benchmark 10-year MGS and UST yields in early April 2013,

the spread has narrowed by 62 bps to 111 bps on 24 December. Similarly, sovereign yield spreads

between MGS and UK Gilts have continued to tighten, increasing the risks of further foreign capital outflows

from Malaysia.

Malaysia’s high household debt is among key economic concerns for the local bond market. The

elevated level of household debt is among the concerns which could amplify the country‟s credit risk. Thus

far, the risk of Malaysia‟s household debt has been mitigated by high household financial assets and low

interest rates. Nonetheless, things may change after the Fed starts to scale back its asset purchases and

the domestic economy reacts to higher inflation in 2014. The concern is that emerging markets – Malaysia

included – may have to raise their benchmark interest rates which make the sustainability of high debt

questionable. This is negative for the bond market.



Slowing regional economic growth is another potential risk. A persistent slowdown in China‟s economy

– the world‟s second largest economy and one of Malaysia‟s top trading partners – will exert additional

pressure on Malaysian financial market and dent investor enthusiasm for MGS against regional sovereign

bonds. A slowdown in India‟s economy is also another concern as the country is an important trading

partner for many Asian nations. In Thailand, the ongoing political turmoil arising from efforts to depose the

present Prime Minister is also weakening its domestic economy, causing the government to downgrade its

growth forecast for 2014. Such negative sentiments in the regional economies, should they prolong, will not

augur well for Malaysia‟s external sector and will affect the country‟s headline growth, causing foreign

portfolio investors to sideline MGS.

Notwithstanding this, there are still factors that will support the MGS market, one of which is the

persistently positive real interest rates and relatively attractive real yields. Although the inflation rate

has picked up since the 2H2013 following a resumption of the government‟s subsidy rationalisation effort,

we do not foresee it to cause real interest rates to turn negative as we anticipate a marginal increase in the

level of the Overnight Policy Rate (OPR) in 2014. In addition, from the perspective of real bond yields, MGS

remain more attractive when compared to sovereign bonds of major advanced and selected regional

countries due to Malaysia‟s relatively low inflation environment.

Another plus point is the federal government’s miniscule external debt and high level of

international reserves which will insulate Malaysia from the impact of capital outflows. Despite the

relatively high total government debt-to-gross domestic product (GDP) ratio, the federal government‟s

external debt remains minuscule, accounting for only 3.2% of total government debt in the 3Q2013.

Meanwhile, Bank Negara Malaysia‟s (BNM) international reserves have increased to RM440.8 billion or

USD135.3 billion as of mid-December 2013 from RM331.3 billion in 2009, which were sufficient to finance

9.4 months of retained imports and were 3.7 times of short-term external debt. The relatively high level of

international reserves will provide a sufficient buffer should there be a rapid withdrawal of foreign capital

from the country.

All in all, we are of the view that long-term foreign investors will continue to support government

papers in the near term. We continue to believe that foreign investors with long-term investment

perspectives (such as sovereign wealth funds, insurance companies, central banks etc) will not totally

abandon local govvies as they are less influenced by changes in the Fed‟s monetary policy stance and tend

to focus more on Malaysia‟s long-term economic fundamentals. Furthermore, domestic institutional

investors will continue to provide their support to the local financial market. This is evidenced from the

growing investible fund size of institutions such as the Employees Provident Fund (EPF), Retirement Fund

Incorporated (KWAP), unit trusts, insurance and Takaful as well as the strong demand for BNM‟s inaugural

30-year note.

We maintain our view of an upside bias for MGS yields and expect the yield curve to steepen further.

This is premised on further improvements in the US economy and labour market which would warrant the

US Fed to continue its tapering plan at a measured pace in 2014. In addition, a slow but steady recovery of

other advanced economies such as the euro zone and Japan would lead to further expectations of capital

outflows from this region – Malaysia included – despite providing a reasonable support to Malaysia‟s

headline GDP growth. On the local front, stronger Consumer Price Index (CPI) growth especially in the

2H2014 on the back of the resumption of the subsidy rationalisation plan and the rollout of the Goods and

Services Tax (GST) in April 2015 will result in higher bond yields following a 25 bps hike in the OPR which

we think will be undertaken by BNM in order to be ahead of the curve to manage higher consumer prices

and possible capital outflows in 2014.

We forecast lower Malaysian government bond issuance amid the government’s effort to gradually

reduce budget deficits. Assuming the budget deficits of RM37.1 billion and RM46.9 billion worth of

MGS/Government Investment Issues (GII) projected to mature in 2014, we expect the Malaysian

government bond issuance to come in at between RM85 billion and RM90 billion. Meanwhile, based on the

2014 MGS/GII issuance calendar announced by BNM recently, there will be a total of 16 auctions for MGS,

12 auctions for GII and 4 auctions for Sukuk Perumahan Kerajaan (SPK), thus raising the auction ratio of

GII-to-MGS to 43:57 from 23:77 in 2008.

As for corporate bonds, we foresee the total issuance in 2014 to moderate slightly when compared

to 2013. Given the government‟s elevated debt level and rapid increases in contingent liabilities, we

foresee less leeway for the government to guarantee future debt. Furthermore, expectations of a

moderation in the overall domestic economy as well as uncertainties over the speed of the US Fed tapering

of bond purchases will likely cause gross corporate bond issuance to moderate slightly to between RM65

billion and RM75 billion in 2014.



We do not foresee broad-based credit deterioration in 2014 although profit margin for corporate

may continue to drag. Judging from the weighted average profit margin of constituents in the FTSE Emas

Index, profitability of the Malaysian companies has moderated to 13.3% as of 27 December compared to

13.8% in 2012. In addition, the leverage levels of the companies under coverage have increased,

evidenced by their increasing total debt-to-total assets ratio to 19.1% as of 27 December (2012: 18.2%).

We are of the view the lower profit margin is mainly due to uncertainties in the external environment as well

as slowing economic growth regionally. Notwithstanding this, we think that corporate earnings have

generally remained stable and that there are no serious concerns regarding overall credit quality. We do not

see broad-based credit deterioration in 2014 due to respectable headline economic growth of circa 5%,

supported by relatively strong private investment and resilient private consumption growth, albeit slower

than in 2013. Our view is that any negative rating will mainly be issuer or sector related.

Based on our rating universe, we continue to see the downgrade-to-upgrade ratio to stay above one

in 2014. The industrial product sector continues to dominate the negative rating actions with its sub-

component, the steel sector, facing depleting margins amidst overcapacity of steel production in China

coupled with softening steel prices. In addition, although we do not anticipate a significant downgrade risk

from the property sector, a slew of cooling measures announced by the government and BNM to rein in

rising house prices could exert downward pressure on property companies‟ profitability, dampening the

sector‟s outlook.

We also maintain an upside bias for private debt securities (PDS) yields. Nonetheless, we expect the

magnitude of increases in corporate bond yields to be smaller than those of MGS, thus narrowing the

corporate yield spread as corporate bonds are less sensitive to external shocks amid low foreign holdings.

In the primary market, investment grade bonds will likely continue to dominate the local bond origination

market while activities for those rated BBB and below will remain lackluster due to wide yield spreads.

Exhibit 1: Timeline of major events in 2013

Source: Bloomberg, MARC Fixed Income Research

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

3.1

2.9

3.0

3.1

3.2

3.3

3.4

MYR/USD (LHS) 10Y UST (RHS)MYR/USD %

GE13

Tapering hints

No taperingsurprise

US debt ceiling crisis

Malaysia's Budget 2014

Taperingannounced



Investors reacted to

Bernanke’s statement on the

possibility of a cutback in

bond purchases in May 2013

Market experienced another

sell-off after June’s FOMC

when Bernanke reiterated

Fed’s intention

But the tone from the Fed

changed by mid-July

Speculation on tapering

resumed in September

Bond market also reacted to

the unexpected 16-day

partial government closure in

October

The Fed unexpectedly

refrained from tapering in

October’s FOMC

By November, the economy

improved further with jobless

rate falling to a 5-year low

The tapering announcement

finally happened in

December

The US Treasury Market

A quick review On 22 May 2013, Ben Bernanke, chairman of the US Fed, hinted to the world that the

central bank is considering scaling back its USD85 billion monthly bond purchases

programme in light of the strengthening job market, a sign of increasing momentum in

economic recovery. Investors immediately reacted to the news by reducing their

holdings of UST in fear of rising yields, pushing the benchmark 10-year UST note yield

to close at 2.04% on that day from 1.63% earlier in the month. The tapering headlines

did not stop there.

The UST market experienced another sell-off after the FOMC meeting in June when

Bernanke reiterated the Fed‟s intention to taper bond purchases and to end it entirely by

mid-2014 given that the economy is finally achieving sustainable growth. During the

meeting, the FOMC emphasised that “the pace, composition, and extent of asset

purchases would continue to be dependent on the Committee‟s assessment of incoming

information for the economic outlook… as well as the economic objectives…”. However,

in his testimony to the House Financial Services Committee in mid-July, Bernanke

stated that the asset purchase programme is highly data-dependent and commented

that the Fed will keep monetary policy accommodative for the foreseeable future given

the PCE inflation rate that was lower than the policymakers‟ 2.0% target and a

persistently high unemployment rate. Since then, the UST market became highly

sensitive to every economic report released, especially those that have a direct impact

on the Fed‟s tapering decision.

The yield for the benchmark 10-year UST notes surged to almost 3.0% in early

September on speculation that the Fed would announce a reduction in bond purchases

after its October FOMC meeting. However, a partial government closure which lasted for

16 days in early October prevented UST yields from rising further. The incident, which

led to furloughs of approximately 800,000 government servants, was finally resolved

when the US Congress reached a last-minute agreement after weeks of standoff, putting

an end to the partial government shutdown and preventing a government default. It was

then agreed that federal agencies would be funded until 15 January 2014 and the debt

ceiling would be suspended until 7 February 2014. Many investors viewed this action as

a temporary stop-gap measure, as the issue is bound to hit the country again in the

coming months.

In the October FOMC meeting, the Fed unexpectedly held its asset purchases intact at

USD85 billion per month, citing that it needed more signs of a sustained recovery and

warning that a hike in interest rates could threaten the country‟s fragile economic

growth. As a result, uncertainties over the Fed‟s tapering decision started to take a toll

on investor sentiment and led to a more volatile market, causing a bearish steepening of

the UST yield curve with the UST 10/5 yield spread widening to 143 bps in late

November, the widest spread for the year and compared to the daily average at about

117 bps in 2013.

By November, economic conditions improved further with the unemployment rate

dropping to a five-year low of 7.0% compared to 8.1% in September 2012, when the

third round of quantitative easing began. About 2.8 million jobs were created over the

same period and the unemployment rate moved closer to the Fed‟s threshold target of

6.5% as stated in its forward guidance policy. The latest unemployment rate also

matched the 7.0% requirement to deliberate an end to the bond purchases programme.

Tapering finally became a reality after the December FOMC meeting when the Fed

outlined its first cutback plan in monthly bond purchases by USD10 billion to USD75

billion starting January 2014. While the Fed‟s move partly eased jitters in the global

bond market, the focus has now shifted to the pace of tapering in the near future. A

rapid move to further trim monthly purchases would signal the Fed‟s confidence about

the recovery, leading to more „blood in the street‟.



We foresee the Fed to scale

back its monthly bond

purchases at a measured

pace

Prospects for 2014: A measured pace of future tapering

We are of the view that the Fed will scale back its bond purchases at a measured pace

due to several reasons. First, the inflation rate as measured by PCE of 0.9% in

November is well below the Fed‟s target of 2.0% and has been trending downward since

2012. Inflation is expected to remain benign in the foreseeable future, giving flexibility to

the Fed to maintain some degree of stimulus to further support the economic recovery.

Secondly, the US housing sector could be threatened by rapid increases in interest

rates. According to the National Association of Realtors, pending home sales in the US

fell by 0.6% in October due to rising property prices and higher mortgage rates following

the Fed‟s tapering announcements. This may prevent policymakers from hastily carrying

out further tapering actions. In addition, Janet Yellen, the incoming chairwoman of the

Fed showed her support for QE3 in her confirmation hearing on 14 November by

commenting that asset purchases are needed to promote a more robust economy and a

reduction of the stimulus policy can only be undertaken when the US economy and

labour market show sustainable improvements.

Exhibit 2: UST yield curve steepened in response to the Fed’s tapering


Exhibit 3: UST 10/5 yield spreads widening


0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2y 3y 5y 7y 10y 30y

% End-2012 Jun-13

Sep-13 End-2013

UST yield curve bearish steepened with right tail of the cuve shifting higher than left tail

90

100

110

120

130

140

150

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5% UST 10/5 (bps, RHS)

UST 10Y (%, LHS)UST 5Y (%, LHS)

bps



Exhibit 4: UST 10/5 yield spreads hit its highest level in November


Exhibit 5: US unemployment rate is moving closer to Fed’s threshold target


Exhibit 6: CPI and PCE inflation are well below the Fed’s target

Source: CEIC, MARC Fixed Income Research

90

100

110

120

130

140

150bps UST 10/5

+1 SD

-1 SD

Mean

UST yield curve steepened with 10/5 yield spread hitting its

highest level in November

4.5

5.5

6.5

7.5

8.5

9.5

10.5-1,000

-800

-600

-400

-200

0

200

400

Jan

-08

Ap

r-0

8

Jul-

08

Oct

-08

Jan

-09

Ap

r-0

9

Jul-

09

Oct

-09

Jan

-10

Ap

r-1

0

Jul-

10

Oct

-10

Jan

-11

Ap

r-1

1

Jul-

11

Oct

-11

Jan

-12

Ap

r-1

2

Jul-

12

Oct

-12

Jan

-13

Ap

r-1

3

Jul-

13

Oct

-13

'000 Change in nonfarm payrolls 3-mma ('000, LHS)Unemployment rate - Inverted Scale (%, RHS) %

Fed's threshold target at

6.5% unemployment rate

QE1 QE2 QE3

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Jan-

08

Apr

-08

Jul-0

8

Oct

-08

Jan-

09

Apr

-09

Jul-0

9

Oct

-09

Jan-

10

Apr

-10

Jul-1

0

Oct

-10

Jan-

11

Apr

-11

Jul-1

1

Oct

-11

Jan-

12

Apr

-12

Jul-1

2

Oct

-12

Jan-

13

Apr

-13

Jul-1

3

Oct

-13

CPI (% y-o-y) PCE Inflation (% y-o-y)

Fed's PCE inflation target at 2.0%

%



Contrary to the Fed, ECB

slashed its key rate twice in

2013

Exhibit 7: A drop in pending home sales index is among the reasons for the Fed to scale back at a gradual pace


Euro Zone and UK Sovereign Bond Market

A quick review Unlike the US Fed, which pledged to reduce its unprecedented stimulus once the

country‟s economy and labour market improve at a sustainable pace, Mario Draghi,

president of the ECB slashed key interest rates twice in 2013. The Refi rate was

reduced to a record low of 0.25% from 0.75% in a 25 bps cut each in the months of May

and November, in view of the strong euro currency and high deflation risk which have

taken their toll on the region‟s economic recovery. As a result, although fears of the

Fed‟s tapering pushed the benchmark 10-year German Bund yields higher by about 61

bps to 1.92% in December from the previous year‟s 1.32%, yields did not spike as much

as of the 10-year UST which surged more than 100 bps. As a result, the spread of these

two sovereign bonds widened to about 110 bps in December, the widest since mid-

2006.

Exhibit 8: 10-year UST/Bund spread widest since mid-2006


-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

May

-12

Jun

-12

Jul-

12

Au

g-1

2

Sep

-12

Oct

-12

No

v-1

2

De

c-1

2

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3

May

-13

Jun

-13

Jul-

13

Au

g-1

3

Sep

-13

Oct

-13

Pending Home Sales (% m-o-m)%

-100

-50

0

50

100

150

Jan-

06

Jun-

06

Nov

-06

Apr

-07

Sep-

07

Feb-

08

Jul-0

8

Dec

-08

May

-09

Oct

-09

Mar

-10

Aug

-10

Jan-

11

Jun-

11

Nov

-11

Apr

-12

Sep-

12

Feb-

13

Jul-1

3

Dec

-13

bps 10Y UST/Bund Spread

-1 SD

Mean

Widest spread since mid

2006

+1 SD



Macro developments

remained a concern as the

rising euro threatened export

and growth performance

\

BOE maintained its policy

rate at 0.5%

And the UK economy has

been recovering at a steadier

pace while the labour market

is strengthening

Yields for UK Gilts rose by

more than one-percentage

point

Macro developments in the euro zone justified the jitters in the financial markets. In

particular, headline CPI grew by a mere 0.9% in November, well below the ECB‟s target

rate of circa 2.0%. Meanwhile, the strengthening of the euro currency by as much as

4.1% year-on-year against the USD also threatened the region‟s exports, exerting more

pressure on the region‟s fragile economic recovery. The latest data in the 3Q2013

showed that the euro zone‟s GDP posted an anemic growth of 0.1%, as the economy

was dragged down by contractions in France and Italy and slower growth in Germany.

Furthermore, the unemployment rate remained stubbornly elevated and hit a historical

high of 12.2% in September, albeit declining slightly to 12.1% in October, bringing the

total number of unemployed people to 19.3 million.

In the UK, the new governor of the BoE unveiled the central bank‟s forward guidance

policy in August in which it promised not to raise the key interest rate from its current

level of 0.5% until the unemployment rate falls to 7.0%. He also added three other

conditions: inflation of not more than 2.5%, medium-term inflation expectations under

control and that unconventional monetary policy does not significantly threaten financial

system stability.

Meanwhile, the country‟s economy is recovering at a steadier pace than its euro-area

neighbours with GDP growing by 0.8% in the 3Q2013 after expanding 0.7% in the

2Q2013, giving a reason for the BoE not to trim the key rate further. Similarly, the UK

labour market is strengthening, with September‟s unemployment rate falling to 7.6%, the

lowest level since 2009. The improvement is also evidenced from payroll numbers which

showed an increase to a record 30 million people during the same period, leading the

BoE to believe that the unemployment rate may decline to 7.0%, the threshold for

considering an increase in the key rate by the 3Q2015, almost a year earlier than

previously forecasted. In the bond market, similar to developments in the UST market,

the yield for the benchmark 10-year UK Gilts had increased by more than one

percentage point by end-December 2013 to 3.02%, compared to 1.83% in the

corresponding period in 2012.

Exhibit 9: ECB Refi, BOE rates, EUR, GBP, Bund and Gilt – 2013 vs. 2012

Source: Bloomberg, BNM, MARC Fixed Income Research

Euro Rates Dec-13 Dec-12 Change

ECB Refinancing Rate 0.25 0.75 -50 bps

EUR 1.37 1.32 4.17%

2-year Bund 0.21 -0.02 23 bps

5-year Bund 0.92 0.30 63 bps

10-year Bund 1.93 1.32 61 bps

30-year Bund 2.76 2.18 58 bps

UK Rates Dec-13 Dec-12 Change

Bank of England Official Rate 0.50 0.50 unchange

GBP 1.66 1.63 1.86%

2-year UK Gilt 0.56 0.32 24 bps


10-year UK Gilt 3.02 1.83 119 bps




Euro zone economy to grow

at sub-par level despite

Germany’s respectable

performance

We are of the view that

ECB’s accommodative

action will prevail in the near

term

Exhibit 10: Euro area and UK GDP since 2008

Source: Bloomberg, BNM, MARC Fixed Income Research

Exhibit 11: 10-year Italy, Spanish and France government bond yields


Prospects for 2014: Slower recovery in the euro zone while Germany and UK will outperform peers For 2014, we continue to believe that the euro zone economy will continue to expand at

a sub-par level with some downside risks. This is despite the favourable performance of

the euro zone‟s largest economy, Germany, which saw the export sector benefitting

from the recovery of the global economy. Germany also experienced an unemployment

rate of 5.2%, less than half of jobless rate in the euro zone as a whole.

All in all, we are still of the view that the region‟s deflationary risk and nascent economic

recovery will likely induce the ECB to maintain interest rates low by pegging its

benchmark refinancing rate at a record low of 0.25% for the foreseeable future. In

addition, the ECB may unveil additional long-term refinancing operations in light of rising

money market rates and the strong euro currency which could slow down the pace of

economic recovery. As for the labour market, we expect that slow recovery in 2014 will

keep the unemployment rate at its current high levels of between 11.5% and 12.0%.

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

1Q08

2Q08

3Q08

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

4Q11

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

3Q13

Euro Area 17 (% y-o-y) German (% y-o-y)

Italy (% y-o-y) France (% y-o-y)

UK (% y-o-y)

%

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

%Italy 10Y Yield (%)Spanish 10Y Yield (%)France 10Y Yield (%)



German Bunds should

continue to outperform the

UST

Better prospects for the UK

and yields for UK Gilts to

trend upward at an almost

the similar pace as UST

Exhibit 12: Euro zone unemployment hit a record high in Sep-2013


With the expectations of the ECB maintaining low interest rates and a tepid recovery in

the euro zone economy coupled with the tapering plan by the US Fed amid signs of

sustainable economic growth, German Bunds should continue to outperform UST with

yield spreads continuing to widen in the year ahead.

As for the UK, the recent upgrade in its growth forecast for 2014 by the International

Monetary Fund (IMF) indicates better prospects for the economy in the near term. The

fact that the BoE now expects the declining unemployment rate to hit the 7% threshold

by mid-2015 rather than by late 2016 as forecasted earlier could mean that the central

bank may tighten its monetary policy earlier than expected. In addition, a strong

correlation between the US and UK financial markets leaves UK Gilts open to the risks

of tapering by the Fed. All in all, we see UK sovereign bonds yields to trend upward at

an almost similar pace as UST in 2014.

Exhibit 13: UK Gilts to track UST closely while Bunds will outperform


0.0

5.0

10.0

15.0

20.0

25.0

30.0%

Euro Area 17 Austria Germany

Italy Portugal Spain

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

Jan-

07

May

-07

Sep-

07

Jan-

08

May

-08

Sep-

08

Jan-

09

May

-09

Sep-

09

Jan-

10

May

-10

Sep-

10

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

% UST 10Y Bund 10Y Gilt 10Y



Government bond issuance

matched our earlier

projection in 2013

We expect MGS/GII

issuance at between RM85

billion and RM90 billion in

2014

With ratio of MGS-to-GII to

narrow further

The Malaysian Government Bond Market

Government bond issuance For the year 2013, the government raised a total of RM92.5 billion from 27 debt auctions, matching our earlier projection of RM90 – RM95 billion, of which about 56% or RM51.5 billion were offered via the MGS market while the remaining were from the GII market. Meanwhile, the government also issued two SPK during the year, raising funds worth RM4.4 billion. As expected, the funds raised were less when compared to the previous year‟s RM96.2 billion amid the government‟s efforts to gradually reduce the country‟s budget deficit to 4% of GDP in 2013, and to a further 3% of GDP by 2015. Assuming the budget deficits of RM37.1 billion in 2014 and RM46.9 billion worth of MGS/GII projected to mature in 2014, we expect MGS/GII bond issuance to come in at between RM85 billion and RM90 billion. Based on the 2014 MGS/GII issuance calendar announced by BNM recently, there will be a total of 16 auctions for MGS, 12 auctions for GII and 4 auctions for SPK.

Exhibit 14: MGS / GII auction result for 2013

Source: FAST, MARC Fixed Income Research

Exhibit 15: SPK auction result for 2013


Looking at the composition profile, consistent with the government‟s objective to

promote the Islamic capital market, the auction ratio of GII-to-MGS has risen rapidly over

the past years and to hit 43:57 in 2014 from 23:77 in 2008. To attract more investors

who are seeking Shariah-compliant assets, it will not be surprising if the government

continues to increase its GII issuance in the coming year, bringing the issuance of GII-

to-MGS to an equal ratio of 50:50 in the near future.

IssuesTenure

(Years)

Target

QuarterTarget Month

Issue

Date

Amount

(RM Mil)

Bid-To-Cover ratio

(x)Average Yield (%)

7-year Re-opening of GII 05/20 3.576% 7 1Q2013 January 08-Jan-13 3,500 2.35 3.49

3.5-year New Issue of MGS (Mat on 07/16) 3 1Q2013 January 15-Jan-13 4,500 2.49 3.17

15.5-year New Issue of GII (Mat on 08/28) 15 1Q2013 February 08-Feb-13 3,000 2.22 3.87

3-year Re-opening of GII 02/16 3.235% 3 1Q2013 February 25-Feb-13 3,500 2.03 3.17

5-year New Issue of MGS (Mat on 03/18) 5 1Q2013 March 01-Mar-13 4,500 1.94 3.26

10-year New Issue of MGS (Mat on 03/23) 10 1Q2013 March 15-Mar-13 4,500 1.65 3.48

7-year Re-opening of MGS 03/20 3.492% 7 2Q2013 April 04-Apr-13 3,500 1.64 3.42

20-year New Issue of MGS (Mat on 04/33) 20 2Q2013 April 15-Apr-13 2,500 2.88 3.84

10.5-year New Issue of GII (Mat on 10/23) 10 2Q2013 April 30-Apr-13 4,000 2.20 3.49

3-year Re-opening of MGS (Mat on 07/16) 3 2Q2013 May 15-May-13 3,500 1.56 2.93

5.5-year New Issue of GII (Mat on 11/18) 5 2Q2013 May 31-May-13 4,000 1.91 3.40

15-year New Issue of MGS (Mat on 06/28) 15 2Q2013 June 14-Jun-13 3,000 1.57 3.73

7-year Re-opening of GII 05/20 3.576% 7 2Q2013 June 28-Jun-13 4,000 1.90 3.75

10-year Re-opening of MGS (Mat on 03/23) 10 3Q2013 July 15-Jul-13 3,500 1.73 3.70

3-year New Issue of GII (Mat on 07/16) 3 3Q2013 July 22-Jul-13 4,000 2.92 3.39

7-year New Issue of MGS (Mat on 07/20) 7 3Q2013 July 31-Jul-13 4,500 1.91 3.89

20-year New Issue of GII (Mat on 08/33) 20 3Q2013 August 30-Aug-13 2,500 1.63 4.58

5-year Re-opening of MGS (Mat on 03/18) 5 3Q2013 September 13-Sep-13 3,500 1.57 3.53

7.5-year New Issue of GII (Mat on 03/21) 7 3Q2013 September 23-Sep-13 3,500 1.75 3.72

30-year New Issue of MGS (Mat on 09/43) 30 3Q2013 September 30-Sep-13 2,500 2.44 4.94

10-year Re-opening of MGS (Mat on 03/23) 10 4Q2013 October 14-Oct-13 3,000 1.55 3.80

5.5-year New Issue of GII Mat on 04/19) 5 4Q2013 October 30-Oct-13 3,000 1.82 3.56

15-year Re-opening of MGS (Mat on 06/28) 15 4Q2013 November 15-Nov-13 2,000 1.55 4.27

10.5-year New Issue of GII (Mat on 05/24) 10 4Q2013 November 22-Nov-13 4,000 1.68 4.44

7-year Re-opening of MGS (Mat on 07/20) 7 4Q2013 November 29-Nov-13 3,000 1.77 4.03

15-year New Issue of GII (Mat on 12/28) 15 4Q2013 December 06-Dec-13 2,000 2.87 4.94

3-year Re-opening of MGS (Mat on 07/16) 3 4Q2013 December 13-Dec-13 3,500 1.57 3.29

IssuesTenure

(Years)

Target

QuarterTarget Month

Issue

Date

Amount

(RM Mil)

Bid-To-Cover ratio

(x)Average Yield (%)

10-year New Issue of SPK (Mat on 03/23) 10 1Q2013 March 22-Mar-13 1,700 1.84 3.73

7-year New Issue of SPK (Mat on 08/20) 7 3Q2013 August 19-Aug-13 2,700 1.53 3.97



Exhibit 16: MGS / GII and SPK auction calendar for 2014


IssuesTenure

(Years)

Target

Quarter

Target

Month

10.5-year New Issue of MGS (Mat on 07/24) 10 1Q2014 January

5-year Re-opening of GII 04/19 3.558% 5 1Q2014 January

15-year Re-opening of MGS 04/30 4.498% 15 1Q2014 February

7-year Re-opening of GII 03/21 3.716% 7 1Q2014 February

3-year New Issue of MGS (Mat on 03/17) 3 1Q2014 March

10-year Re-opening of GII 05/24 4.444% 10 1Q2014 March

7.5-year New Issue of MGS (Mat on 09/21) 7 1Q2014 March

15-year Re-opening of GII 12/28 4.943% 15 2Q2014 April

5.5-year New Issue of MGS (mat on 10/19) 5 2Q2014 April

20-year Re-opening of MGS 04/33 3.844% 20 2Q2014 May

3.5-year New Issue of GII (Mat on 11/17) 3 2Q2014 May

10-year Re-opening of MGS (Mat on 07/24) 10 2Q2014 May

7-year Re-opening of GII 03/21 3.716% 7 2Q2014 June

3-year Re-opening of MGS (Mat on 03/17) 3 2Q2014 June

20-year Re-opening of GII 08/33 4.582% 20 2Q2014 June

5-year Re-opening of MGS (Mat on 10/19) 5 3Q2014 July

15-year Re-opening of GII 12/28 4.943% 15 3Q2014 July

7-year Re-opening of MGS (mat on 09/21) 7 3Q2014 August

10-year Re-opening of GII 05/24 4.444% 10 3Q2014 August

3-year Re-opening of MGS (Mat on 03/17) 3 3Q2014 September

30-year Re-opening of MGS 09/43 4.935% 30 3Q2014 September

5-year Re-opening of GII 04/19 3.558% 5 3Q2014 September

15-year Re-opening of MGS 04/30 4.498% 15 4Q2014 October

3-year Re-opening of GII (Mat on 11/17) 3 4Q2014 October

10-year Re-opening of MGS (Mat on 07/24) 10 4Q2014 November

5-year Re-opening of MGS (Mat on 10/19) 5 4Q2014 November

10-year Re-opening of GII 05/24 4.444% 10 4Q2014 December

7-year Re-opening of MGS (Mat on 09/21) 7 4Q2014 December

IssuesTenure

(Years)

Target

Quarter

Target

Month

10-year new Issue of SPK (Mat on 02/24) 10 1Q2014 February

7.5-year New Issue of SPK (Mat on 10/21) 7 2Q2014 April

10-year Re-opening of SPK (Mat on 02/24) 10 3Q2014 August

7-year Re-opening of SPK (Mat on 10/21) 7 4Q2014 October



Foreign holdings of MGS

dropped following Fed’s

tapering plan talks in May

2013

But some capital flowed back

after the Fed surprised the

market

Ringgit weakened by as

much as 8.3% following the

outflows of capital

Exhibit 17: MGS and GII bonds issuance trends

Source: BPAM, FAST, MARC Fixed Income Research

Macroeconomic factors influencing local bond market

Negative Factors

Impact of the planned tapering by the Fed

Following Chairman Ben Bernanke‟s tapering talks in mid-May, foreign holdings of MGS

dropped for four consecutive months from May to August 2013, the longest stretch since

April 2009. In addition, Fitch Ratings‟ revision of Malaysia‟s sovereign credit outlook to

„negative‟ from „stable‟ in July fueled outflows of foreign capital from the country,

triggering a sell-off in the equity and bond markets, a depreciation of the ringgit against

the USD, and rising bonds yields. As of end-September, foreign investor holdings

dropped to RM128.12 billion, equivalent to 42.8% of total outstanding MGS compared to

the peak of RM144.98 billion in April this year. As of October, foreign investors sold

about RM6.6 billion worth of MGS compared to the highest holdings back in April.

However, some foreign funds were back into the local market after the US Fed surprised

the market by deciding to maintain its monthly bond purchases programme at USD85

billion during the FOMC meeting in late October, leading investors to believe that the

central bank will delay its tapering plan until the 1Q2014. By December however, the

Fed finally announced its tapering plan to cut back USD10 billion from its monthly

purchases starting January 2014.

With the relatively high foreign holdings of MGS, the ringgit was sensitive to the US

Fed‟s tapering plan even before the actual cutback was announced in mid-December.

The ringgit weakened by as much as 8.3% to RM3.33 in August, the weakest level since

mid-2010 as foreign investors trimmed their holdings of MGS. Despite recovering some

of its losses in the following months after the Fed unexpectedly refrained from winding

down its stimulus policy, the local currency still posted a loss of 7.1% year-on-year in

2013, the worst annual drop since the Asian Financial Crisis.

43.5

60.0

37.1

57.354.2

51.5

16.5

28.5

21.0

36.0

42.0 41.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

2008 2009 2010 2011 2012 2013

MGS GIIMYR bil



CDS also reacted to Fed’s

tapering plan, climbing to

158 bps

But retreated to below +1.0%

of its SD by September

Ballooning household debt is

a concern especially if

interest rates were to rise

Exhibit 18: Ringgit vs. foreign holdings of outstanding MGS

Source: BNM, CEIC, MARC Fixed Income Research

In the CDS market, the price of Malaysia‟s five-year CDS, which was trading below 1.0 standard deviation before Bernanke hinted at tapering in May, hit its highest level for the year at 158 bps as investors rushed for safe haven instruments following US Secretary of State John Kerry‟s comments that there was firm evidence of the Syrian government using chemical weapons against its own people, triggering worries over the possibility that the US government will lead a military strike against Syria. Nonetheless, waning concerns of a possible US-led strike coupled with the unexpected decision by the Fed to delay its tapering plan after its September FOMC meeting brought the CDS price sharply lower to slightly below its +1.0 standard deviation level. Exhibit 19: Malaysia’s CDS market responded to the Fed’s tapering news


Household debt and narrowing current account surplus are the

primary concerns

Ballooning household debt is an area of concern which could amplify the country‟s credit

risk. Malaysia‟s household debt-to-GDP ratio reached a record high of 82.9% in the

3Q2013, among the highest among Asian countries. Thus far, the risk of Malaysia‟s

household debt has been mitigated by high household financial assets and low interest

rates. Nonetheless, things may change after the Fed starts to scale back its asset

purchases and the domestic economy reacts to higher inflation in 2014. The concern is

that emerging markets – Malaysia included – may have to raise their benchmark interest

rates which make the sustainability of high debt questionable. This is negative for the

bond market.

2.8

2.9

3.0

3.1

3.2

3.3

3.4

3.5

3.6

3.7

3.85.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

55.0

Foreign Holdings of Outstanding MGS (%, LHS)

MYR/USD (RHS)% MYR/USD

60

80

100

120

140

160

180

Malaysia 5Y CDS

+1 SD

-1 SD

Mean

bps



Declining CA surplus and

lingering budget deficits are

also ‘credit negative’ for

Malaysia

Sovereign yield spreads

have narrowed making it less

appealing for MGS

Exhibit 20: Ballooning household debt amplify the country’s credit risk

Source: BNM, CEIC, MARC Fixed Income Research

In addition, a narrowing current account surplus and a decade-long budget deficit are

among other concerns raised by Fitch Ratings. Despite a seri¬es of fiscal-tackling

measures that were announced during the tabling of Malaysia‟s Budget 2014, including

the timeframe for the implementation of the GST and the resumption of the subsidy

rationalisation plan, Fitch maintained the country‟s „negative‟ outlook stating that policy

implementation “remains key to limiting further credit pressure on the sovereign rating”.

Narrowing of sovereign spreads

Given the rising yields in the major developed countries, sovereign yield spreads of

MGS against their sovereign bonds are narrowing, tempering investor appetite for MGS

as they shift their interest to major sovereign bonds which are now offering rising yields.

Compared to the widest sovereign spread of 173 bps between the benchmark 10-year

MGS and UST yields in early April 2013, the spread has narrowed by 62 bps to 111 bps

on 24 December. Similarly, sovereign yield spreads between MGS and UK Gilts

continued to tighten, increasing the risks of further foreign capital outflows from

Malaysia. A similar trend was observed regionally where yields of several countries‟

sovereign bonds climbed faster than the MGS, making the latter less attractive

compared to regional peers‟ local govvies.

Exhibit 21: Narrowing sovereign spread has dampened demand for MGS


55.0

60.0

65.0

70.0

75.0

80.0

85.0 Household debt-to-GDP (%)%

-600

-550

-500

-450

-400

-350

-300

-250

-200

-150

-100

0

50

100

150

200

250

MGS/UST (bps, LHS) MGS/Gilt (bps, LHS)

MGS/Indonesia (bps, RHS) MGS/India (bps, RHS)



Slower economic growth

momentum in China is also

negative for Malaysia

A slowdown in regional

economies – India,

Indonesia and Thailand – if it

prolongs, will also be

negative for Malaysia

On the positive side, real

interest rates will likely

remain positive as we expect

an increase in the OPR in

2014

Slowing regional economic growth

Apart from the anxiety over the Fed‟s tapering plan, another potential risk stems from

slower economic growth in regional countries, particularly in the Chinese economy

where medium-term growth prospects are clouded by changes in economic

fundamentals, risking the economy from sustaining its strong growth trajectory despite

the better-than-expected expansion in the 3Q2013. As the world‟s second-largest

economy and one of Malaysia‟s largest export markets, a persistent slowdown in

China‟s economic growth will exert more pressure to the Malaysian financial market and

make MGS less attractive against regional sovereign bonds.

A slowdown in India‟s economy is also another concern as the country is an important

trading partner for many Asian nations. India‟s growth momentum is under pressure due

to rising interest rates caused by high inflationary pressure. Indonesia‟s economy is also

moderating with growth slipping to below 6% in the 3Q2013, while in Singapore,

continuous pressure to address the problem of high property prices has caused the

property sector to be hit in the 3Q2013. In Thailand, ongoing political turmoil arising from

efforts to depose the present Prime Minister is weakening the domestic economy,

causing the government to downgrade its growth forecast for 2014 to between 4% and

5%. Such negative sentiments in the regional economies, should they prolong, will not

augur well for the Malaysian economy. Notwithstanding, the ongoing improvement in the

US economy as well as some stabilisation in the euro zone are providing an important

boost to global economic conditions which would prevent investors from completely

fleeing the MGS market.

Positive factors

Persistent positive real interest

In response to capital outflows, inflation and weakening currencies, some Asian central

banks have raised their benchmark interest rates in recent months. For instance, Bank

Indonesia pushed up its benchmark interest rate by five times in 2013 with cumulative

increases of 175 bps since early June to 7.50%. Similarly, the Reserve Bank of India

revised upward its benchmark repurchase rate (repo rate) for two consecutive months in

October and November by 25 bps each to 7.75% from 7.25% in September. As for

Malaysia, although BNM has maintained the OPR at 3.0% throughout 2013, we believe

that the rising inflation rate in 2014 coupled with additional capital outflows in the wake

of the Fed‟s tapering actions will induce BNM to raise the policy rate by 25 bps, keeping

the real interest rate positive.

Exhibit 22: Real interest rate: Malaysia vs. selected countries


-3-2-2-1-10112Malaysia

US

UK

EuroThailand

India

Indonesia



Real yields for MGS are also

higher than some sovereign

bonds

Malaysian government

external debt remains low

and high level of

international reserves will

provide sufficient buffer

should there be outflows

In addition, investment returns based on real yields still favour MGS when compared to

major sovereign bonds and selected regional bonds due to Malaysia‟s relatively low

inflation environment. In our view, such a scenario will limit the outflows going forward.

For example, after adjusting for inflation, the benchmark 10-year real yield for MGS

(1.19%) is higher than that for UK Gilts (0.88%), German Bunds (0.59%) and JGBs (-

0.82%).

Exhibit 23: Persistent positive real interest rate offered by Malaysia


Exhibit 24: 10-year real yield: MGS vs. major sovereign bonds


Minuscule federal government external debt

Despite a relatively high total government debt-to-GDP ratio, the federal government‟s

external debt remains minuscule, accounting for only 3.2% of total government debt in

the 3Q2013. In addition, the government‟s external debt-service ratio continued to

decline to 0.1%. Meanwhile, BNM‟s international reserves increased to RM440.8 billion

or USD135.3 billion as of mid-December 2013 from RM331.3 billion in 2009, sufficient to

finance 9.4 months of retained imports and are 3.7 times of the short-term external debt.

The relatively high level of international reserves will provide a sufficient buffer should

there be a rapid withdrawal of foreign capital from the country. At the same time, the

long-term trend of the government‟s external debt remains favourable as it has been

declining since June 2003 before hovering around RM16 billion to RM18 billion in the

past two years.

Period Malaysia US UK Euro Thailand India Indonesia

Mar 11 -0.25 -2.45 -3.50 -1.70 -0.64 -2.93 0.10

June 11 -0.50 -3.35 -3.70 -1.45 -1.06 -2.01 1.21

Sept 11 -0.40 -3.65 -4.70 -1.50 -0.52 -1.75 2.14

Dec 11 0.00 -2.75 -3.70 -1.70 -0.28 0.76 2.21

Mar 12 0.90 -2.45 -3.00 -1.70 -0.45 0.81 1.78

June 12 1.40 -1.45 -1.90 -1.40 0.44 0.42 1.22

Sept 12 1.70 -1.75 -1.70 -1.85 -0.38 -0.07 1.44

Dec 12 1.80 -1.45 -2.20 -1.45 -0.88 0.69 1.45

Mar 13 1.40 -1.25 -2.30 -0.95 0.06 1.85 -0.15

June 13 1.20 -1.55 -2.40 -1.10 0.25 2.09 0.10

Sept 13 0.40 -0.95 -2.20 -0.60 1.08 0.45 -1.15

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0UST

MGS

GiltBund

JGB



We do not anticipate

massive outflows due to the

stable demand for local

govvies from international

institutional investors

…as well as demand from

domestic institutional

investors

We maintain an upside bias

of MGS yields and expect

the yield curve to steepen

However, the MGS will likely

be sufficiently supported by

demand from institutional

investors

Exhibit 25: Declining government external debt is favourable to investment


Sufficient support from domestic investors

We continue to believe that foreign investors will not totally abandon local govvies as

long-term investors such as sovereign wealth funds, insurance companies and other

institutional investors are less influenced by changes in the US Fed‟s monetary policy

but tend to focus more on Malaysia‟s long-term economic fundamentals. Indeed, we see

the current level of capital outflow as a healthy phenomenon given that the massive

global liquidity in the past few years has driven up Malaysia‟s asset prices and

household debt significantly.

Furthermore, the Malaysian bond market has consistently been supported by large

domestic institutional investors such as KWAP, the EPF and insurance companies. This

is evidenced by the growing investible fund size of institutions such as the EPF, KWAP,

unit trusts, insurance and Takaful companies. Strong demand from domestic investors

was also seen during the debut of BNM‟s inaugural 30-year MGS note – a highly sought

after instrument by long-term investors – which was oversubscribed by 2.44x despite it

being offered at a time when foreign capital was flowing out from the country.

Given these reasons, we continue to opine that domestic institutional investors will lend

support to the local govvies market, mitigating some of the impact from a reversal of

global capital flows back to developed economies after the Fed scales back its asset

purchases programme.

Our View : Maintain Upside Bias on MGS Yield Curve We maintain our view of an upside bias for MGS yields and expect the yield curve to

steepen further from the current level in the wake of an improving US economy and

labour market which would warrant the US Fed to continue its tapering plan at a

measured pace in 2014. Secondly, a slow but steady recovery of other advanced

economies including the euro zone and Japan would lead to further expectations of

capital outflows from this region – Malaysia included - despite providing a reasonable

support to Malaysia‟s headline GDP growth. Thirdly, on the local front, stronger CPI

growth especially in the 2H2014 on the back of the resumption of the subsidy

rationalisation plan and the rollout of the GST planned for April 2015 will further exert

upward pressures on bond yields. Our economics team believes that BNM will raise the

benchmark OPR by 25 bps in order to be ahead of the curve in dealing with higher

consumer prices and possible capital outflows in 2014. Notwithstanding rising yields, we

are of the view that MGS will be sufficiently supported by demand from institutional

investors.

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0 Govt External Debt-to-Total Govt Debt (%)%



Primary market activities

were quieter in 2013 when

compared to the bumper

year of 2012

Exhibit 26: Malaysia’s real GDP, CPI and OPR


The Ringgit Corporate Bond

Corporate bond issuance Primary market activities for the year 2013 were relatively quiet compared to the bumper

year of 2012 even after excluding the RM30.6 billion issued by PLUS Bhd in 2012

(RM19.6 billion and RM11.0 billion for the AAA-rated and GG-unrated segments

respectively). For the year 2013, gross corporate bond issuances fell by 30% to RM86.2

billion compared to RM123.8 billion issued in the preceding year. On a year-on-year

basis, lower bond issuances were mainly dragged down by smaller issuances from the

unrated quasi-government sector and rated corporate bonds which fell by RM16.9 billion

and RM24.2 billion respectively although Cagamas increased its issuance by RM4.5

billion.

Exhibit 27: Corporate bond issuance trends

Source: BPAM, MARC Fixed Income Research

For the year 2013, the utilities sector dominated primary market activities with a total

RM27.7 billion raised. The AA-rated Malakoff Power issuance alone amounted to

RM10.98 billion, followed by the Cagamas issuance of RM7.9 billion. Activities in the

primary market continued to be dominated by investment grade bonds while it remained

inaccessible for those rated BBB and below, implying that high-risk borrowers will

continue to face difficulty in raising capital in this market.

1.0

1.5

2.0

2.5

3.0

3.5

4.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0Real GDP (% y-o-y, LHS) CPI (% y-o-y, LHS)

OPR (%, RHS)

% %

20.0

40.0

60.0

80.0

100.0

120.0

140.0

2008 2009 2010 2011 2012 2013

Rated Corporate Bonds Unrated Corporate Bonds

Unrated GG Cagamas

RM bil



Islamic PDS issuances will

likely increase more in

response to government’s

initiative to promote Islamic

capital market

Profitability of companies

has moderated but broad-

based credit deterioration is

not likely

Any negative rating will likely

be issuer or sector- related

Exhibit 28: 2013 Corporate bond issuance : Industry and rating distribution

Source: BPAM, MARC Fixed Income Research

With the government‟s efforts to promote the Islamic capital market, it is not surprising to

see Islamic PDS issuances increased during the year. Going forward, we are of the view

that the Securities Commission‟s stricter Shariah-compliant rules which took effect from

29 November 2013 would induce some companies to convert their conventional debt to

Islamic debt, raising the Islamic-to-conventional debt ratio.

Given the government‟s elevated debt level and rapid increases in contingent liabilities,

we foresee less leeway for the government to guarantee future debt. Furthermore,

expectations of a moderation in the overall domestic economy as well as uncertainties

over the speed of the US Fed tapering of bond purchases will likely cause gross

corporate bond issuance to moderate slightly in 2014 to between RM65 billion and

RM75 billion.

Lower profit margin but no worrying signs Judging by the weighted average profit margin of constituents in the FTSE Emas Index,

the profitability of Malaysian companies has slightly moderated to 13.3% as of 27

December compared to 13.8% in 2012. In addition, the leverage levels of companies

under coverage have increased, evidenced by their increasing total debt-to-total assets

ratio to 19.1% as of 27 December 2013 (2012: 18.2%). We are of the view the lower

profit margin is mainly due to uncertainties in the external environment and slowdown in

regional economic growth. Nonetheless, we think that corporate earnings have generally

remained stable and that there are no serious concerns on the overall credit quality. We

do not see broad-based credit deterioration in 2014 due to respectable headline

economic growth of circa 5%, supported by the relatively strong private investment and

resilient private consumption growth, albeit slower than in 2013. Our view is that any

negative rating will mainly be issuer or sector-related.

0.1

0.2

0.4

1.8

2.3

2.3

3.2

11.1

13.9

32.2

32.5

Mining & Petroleum

Industrial Products

Consumer Product

Trading & Services

ABS

Transportation

Plantation

Property & …

Conglomerate

Utilities

Financial

0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0

%

AAA29.2

AA69.0

A1.8



We anticipate the

downgrade-to-upgrade ratio

to remain above one in 2014

Number of defaults rose in

2013 but concentrated in

industrial product sector

Exhibit 29: FBMEmas Index : Financial analysis


In 2013, the downgrade-to-upgrade ratio based on the issue count in MARC‟s universe

rose to 8.0x (Upgrade: 1; Downgrade: 8) compared to 7.3x in the previous year. At this

juncture, we continue to expect to see the downgrade-to-upgrade ratio to stay above

one in 2014 with the industrial product sector continuing to dominate negative rating

actions. The steel sector, a sub-component of the industrial product sector, will continue

to face depleting margins amidst overcapacity of steel production in China coupled with

softening steel prices. In addition, although we do not anticipate a significant downgrade

risk from the property sector, a slew of cooling measures announced by the government

and BNM to rein in rising house prices could exert downward pressure on property

companies‟ profitability, dampening the sector‟s outlook.

Meanwhile, the number of defaults fell to 2 issues from the previous year‟s 7 issues.

Again, default cases were mostly concentrated in the industrial product sector, led by

Kinsteel Bhd and Perwaja Steel Sdn Bhd. MARC has downgraded Kinsteel Bhd‟s

RM100 million Murabahah Commercial Papers/Medium Term Notes Programme to DID

from MARC-4ID / CID following the company‟s failure to redeem its outstanding RM40

million Murabahah CP on 5 September 2013. Meanwhile, Perwaja‟s RM400 million

Murabahah MTN programme was downgraded to DID from CID after the company‟s

failure to meet repayment of its RM50 million MTN due on 25 September 2013.

Exhibit 30: Rating migration in MARC universe by issue count

Source: MARC Fixed Income Research

2013 (YTD*) 2012 Changes

FBMEmas Index 12815.8 11438.1 1377.7

Sales per Share (MYR) 5714.0 5876.4 (162.37)

Profit Margin (%) 13.3 13.8 (0.57)

Operating Margin (%) 16.6 17.5 (0.87)

Return-on-Asset (%) 2.6 2.8 (0.18)

Total Debt-to- Total Equity (%) 81.7 81.7 (0.05)

Total Debt-to-Total Assets (%) 19.1 18.2 0.9

* as of 27 December 2013

6

12

3 31

26

3032

22

8

12

8

3

7

2

0

5

10

15

20

25

30

35

40

2009 2010 2011 2012 2013

Upgrade Downgrade Default



We maintain an upside bias

for corporate bond yields on

the back of a steepening

government bond yield curve

Investment grade bonds will

likely dominate local bond

origination

Exhibit 31: Rating migration by sector in MARC universe for 2013

Source: MARC Fixed Income Research

PDS Outlook As with the trend in the sovereign bond market, we maintain an upside bias for

corporate bond yields on the back of a steepening government bond yield curve.

Nonetheless, we expect the magnitude of increases in corporate bond yields to be

smaller than those of MGS, thus narrowing the corporate yield spread as corporate

bonds are less sensitive to external shocks amid low foreign holdings. At the same time,

the corporate bond market is not expected to be as volatile as the local govvies market

and shrinking transaction volumes are expected as investors continue to stay on the

sidelines in response to uncertainties over the speed of the tapering by the US Fed, and

the global economic landscape.

In the primary market, investment grade bonds will likely continue to dominate the local

bond origination market while the market will remain lackluster for those rated BBB and

below. Looking at the Exhibit 31, we attribute the relatively wide yields spread of this

rating segment compared to higher rated bonds as a main deterrent to issuers rated A

and below from entering the primary market.

Exhibit 32: Wide yield spreads for A-rated and below is the main reason that deterring these borrowers from local bonds market

Source: Bloomberg, BPAM, MARC Fixed Income Research

Issue

Count

Issue Size

(RM mil)

Issue

Count

Issue Size

(RM mil)

Issue

Count

Issue Size

(RM mil)

Industrial Products 3 724 2 500

Infrastructure & Utilities 4 6,180

Consumer Products 1 300

Technology 1 10

Total 1 10 8 7,204 2 500

Sector

Upgrade Downgrade Default

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0%

5Y MGS 5Y AAA 5Y AA1

5Y A1 5Y BBB1



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