Government bond issuance, which ballooned to a record high in 2009, is set to decline in 2010. At present, we are looking at a potential MGS/GII gross issuance size of RM60 billion-RM65 billion for the full year, about 29% lower than the issuance size in 2009.

This estimate takes into consideration a budget deficit target of 5.6% of gross domestic product (GDP) and RM23.4 billion debts maturing in 2010. As such, supply pressure, which was a dominant theme in the investing community in 2009, may no longer be a sole influencing factor, and this should ease valuation pressures, particularly at the long end of the curve.


Corporate bond issuance: Issuance to surpass 2009 levels
We expect to see a pick-up in primary market activity in 2010 and that the healthy issuance pace since 2H2009 is likely to continue. New corporate bond issuance in 2010 is expected to be approximately RM50 billion (2009 estimate: RM45 billion). The dynamics behind the potential new issuances of corporate bonds are as follows:

•    The economy is expected to generate growth momentum, albeit below the potential output level, with our economic research team is looking at a 3.6% year-on-year (y-o-y) gain in real GDP. The improvement in economic activity will translate to higher financing needs among corporations.

•    Financing costs, which ballooned in the aftermath of the global financial crisis about the same time last year, has retreated significantly. As such, companies will be able to meet financing requirements with relative ease and at affordable cost. The average cost of borrowing for a high grade (AAA & AA) currently stands at 4.4% compared to 5.1% about a year ago.

•      The introduction of Danajamin Nasional Bhd, which reportedly has the capacity to guarantee up to RM15 billion worth of bonds, is an extra added flavour to the primary market. As at September 2009, according to Danajamin, it has received four applications with a total size of RM1 billion, and 30 other companies have enquired with a potential issuance size of RM8.4 billion, according to a newspaper report. However, as at the date of this report, no Danajamin-wrapped issue has taken place.

•      On the demand side, with recovery looking to be well on track based on the recent Institute of Supply Management (ISM) numbers in the US, we do not see another episode of a massive flight-to-quality into the safe-haven of government papers this time around, which is positive for corporate bonds demand. Moreover, despite spread compression taking place since 2Q2009, premiums offered to investors presently are reflective of a more stable market. Nonetheless, we would like to note here that risk aversion has not completely abated, which is understandable given the structural problems that led to the worst financial crisis since the Great Depression. As such, investors’ risk tolerance along the credit curve may be halted at AA band and issuers rated lower than that may have to opt for credit wrapping to raise funds.

Foreign Holdings: Short USD/RM position on dollar weakness to boost holdings among foreigners
Foreign holdings of government securities reached a record high of 25% in the middle of 2008 when the ringgit was on a bullish run against the greenback. Nevertheless, since the beginning of the credit crunch episode, investors’ pursuit of a safe-haven currency dampened the valuation of emerging currencies. Foreign holdings of MGS then fell to 12.5% in 1Q2009. This time around, we foresee a strong buying interest by foreigners mainly on the upside potential of the ringgit against the USD. Assuming the USD/MYR trade at 3.15 on average in 2010, foreign holdings as a percentage of outstanding MGS is expected to climb to 21%, ceteris paribus.


Bond yields: Inflation and growth story to resurface
When we published our 2H2009 Bond Market Outlook on July 2, 2009, we wrote that “Mr Market” has completely ignored the significance of inflation and uncertainty in economic growth for most part of 2009.

Bond yields have hardly reacted to the deflationary environment, and looking where the 10-year yield was traded, it seems like players were pricing in an economic growth of above 4%. This anomaly can be explained by the ballooning government bond issuance in 2009, and our view is that supply pressures have significantly downplayed the economic uncertainty.

Going into 2010, however, we believe that inflation and economic growth could resurface as investment themes in the rates market given that supply concern will no longer be a major factor.

We do not expect a straightforward recovery from the recent economic downturn due to the catastrophic magnitude of the recession as it was driven by a slump in the developed financial markets. It normally takes longer for a meaningful and sustainable recovery to take effect if economic recession is driven by a financial crisis. Furthermore, the state of sustainable economic recovery in the US presently hinges on the labour market, where the unemployment rate reading shows that the job market is still fragile.

Apart from a still-weak US labour market, the tail risk to this recovery may also come from further bank writedowns, new “smaller scale debt crisis episode “ (ala Dubai World) and premature exits from stimulus policies by governments.

Nevertheless, a rebound in the US ISM new orders has looked encouraging thus far, which is a positive development for Asia’s exports. We also previously indicated that Asia’s export should rebound in 4Q2009, judging from its relationship with ISM new orders. Based on the recent numbers, we are seeing exports rebounding in the month of November, with the rate of decline diminishing to 4.8% compared to an average annual rate of decline of 22% from January to October 2009.

We opine that Asia exports should print an average growth of 10.4% in 1H2010 after slumping into negative territory since November 2008.

On the inflation front, the deflationary environment should come to an end in the early part of 2010, and inflation should be back as a concern in the investing community with our economic team is currently looking at inflation rate of 2.4% in 2010.

Before we proceed further, it is worth noting that inflation threats highlighted thus far are more cost-push in nature rather than demand-pull. Our assessment is that inflation threats may come from the following sources:

•       Crude oil and food prices have gained 140% and 20% respectively from the trough of the commodity cycle in December 2008, raising concerns on a cost pass-through to consumers.

•       The potential introduction of goods and services tax (GST) and the new system of petrol subsidy which translates into higher expenses.


Players have reacted to expectations of an interest rate hike
Bank Negara Malaysia (BNM), in its first Monetary Policy Committee (MPC) meeting of the year, kept the benchmark rate unchanged at 2% as expected, citing that “...recent economic indicators suggest that the economy expanded favourably in the fourth quarter of 2009.

“Positive developments in manufacturing production, financing activity, external trade and labour market conditions reaffirm the assessment that the economic recovery is gaining strength. Going forward, the economy is expected to expand further in 2010, with growth being supported by strengthening domestic demand, particularly private consumption, and further improvements in external demand.”

The final paragraph of the MPC statement, however, caught the market by surprise as it highlighted that the committee recognises the need to ensure that the monetary policy is appropriate to prevent the build-up of financial imbalances that could arise from interest rates being too low for a prolonged period of time.

That statement was seen as a hint that the central bank may be hiking the policy rate sooner than expected and some economists are looking at a policy rate alteration as early as 1Q2010.

As far as the ringgit rates market is concerned, we have seen players reactions to expectations of a higher interest rate evidenced by a sharp increase on yields at the shorter end of the curve. The yield on the three-year benchmark MGS has climbed to 3.35% after the first MPC meeting of the year.

The yields at the longer end of the curve, however, have hardly moved as it is more sensitive to inflation expectations. The 10-year benchmark MGS notes, for instance, were last seen at 4.27%. The rate hike, if any, is likely to come in gradually, and the common quantum we have seen historically is around 25 basis points (bps) per announcement.

That being the case, we may not see further reaction as the current level of three-year yields is already more than 130 bps above the overnight policy rate (OPR), even wider than the previous rate hike cycle experienced in late 2005 and early 2006.


Lowered credit risk premiums
Following the continuous flow of positive economic data abroad and domestically, demand for risky asset classes strengthened as reflected by buoyant sentiment in equities, where the benchmark FBM KLCI index gained almost 50% since the trough of the financial crisis in 1Q2009, sending the equity risk premium lower.

Similarly, credit risk premiums also lowered over the same period where the spread of three-year AA to MGS of similar maturities narrowed to 120 bps from its peak of 240 bps over the same period, reflective of a more stable credit market environment at present.

The spread is currently half of the level seen during the peak of credit market crisis in 1Q2009, a manifestation of increasing investors’ confidence given the continuous improvement in incoming economic and financial data. Despite significant compression in the corporate spread, we think that credit spread along the AA papers could potentially tighten by another 20–30 bps in 1H2010.

This call is derived based on the assumptions of further sell-offs in the ringgit sovereign bonds, persistent bullish equities run and consistent flow of positive economic data in 2010 which is expected to reduce the demand for the safe haven of government bonds.


Wan Murezani Wan Mohamad is head of Fixed Income Research, MARC


This article appeared in The Edge Financial Daily, February 8, 2010.