Last week, as widely expected, Bank Negara Malaysia kept the overnight policy rate (OPR) at 2%, the seventh time it has done so since April last year. No surprises there. The surprise was the last line in the monetary policy committee’s (MPC) statement which hinted of the possibility of higher rates sooner rather than later. 

“…the MPC also recognises the need to ensure that the stance of 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,” the press release reads.

Note also that Malaysia’s consumer price index turned positive in December, rising 1.1% y-o-y after six months of deflation. 

The MPC statement prompted CIMB Research, Maybank Investment Bank and RHB Research Institute to adjust their calls on the OPR, with expectations of a hike earlier than their previous forecasts. Maybank foresees a rate hike as early as March.

Karen Wan, credit analyst for treasury & markets at AmBank (M) Bhd, notes that quite a lot of the negatives arising from interest rate hike expectation and supply pressure has been priced into the fixed income market. Hence, the impact on yields when the central bank eventually raises rates may be partly mitigated. Typically, yields track interest rate movements while interest rate pressures cause investors to demand higher yields, putting downward pressure on bond prices which leads to capital loss for the bond holder.

Wan takes the view that the shift towards a more hawkish statement by the MPC hints at potential rate hikes this year. 

“Most investors understand a rate hike will come eventually but they also see a cap on any major downside risk on yields because the spreads between MGS (Malaysian Government Securities) yields and the OPR are still very rich and offer a lot of buffer,” she says.

She adds that lower issuance of MGS in 2010 is another mitigating factor that may keep yields range bound. Gross issuance of MGS is expected at RM64 billion this year compared with RM88.5 billion last year, while net issuance this year is expected at RM40.5 billion compared with RM52 billion last year. 

“There’s less supply pressure this year. Last year, yields were affected by the record amount of supply,” says Wan, noting that yields have also been on a gradual uptrend since early last year on prospects of a rising fiscal deficit.  

Wan Murezani Wan Mohamad, vice-president, fixed income research at Malaysian Rating Corp Bhd (MARC), agrees that government bond yields have been trending upwards across the board since early 2009, mainly driven by supply concerns as the government’s financing needs increased with its huge stimulus package. The rising trend disappeared in the second half as the market believed the ballooning MGS issuance could be absorbed due to the abundant liquidity in the domestic financial market.

By the end of last year however, the yield on the three-year MGS rose as high as 3.3% compared to 2.93% in 3Q2009. The spread between the three-year and the OPR stood at 130 basis points, Wan Murezani notes.

“The spread level is almost identical to the one experienced during the previous rate hike cycle seen in 2005. Furthermore, the average spread during the OPR status quo period from May 2006 to November 2008 stood at 20 bps. In short, the faster rate of increase in bond yields at the short end of the curve seen of late indicates that players have reacted to expectations of a rate hike,” he explains.

Wan Murezani sees the MPC statement as a reminder that despite low interest rates, the central bank is monitoring the pressure from rising price levels to ensure a proper balance between economic growth and inflation. He takes the view that monetary policy support is still needed at this juncture to sustain the economy.

“Hence, the bias for a rate hike, if any, will start to emerge in the later part of 2010, in my view,” he says, adding that local rates will lag behind regional and major central banks.

“When that happens, then we expect the short end of the curve to react by further pricing in the probability of monetary tightening, and yields along this tenure are expected to increase at a faster rate than its long-end counterpart,” Wan Murezani explains.

However, he does not expect this in 1Q as investors and the authorities will likely adopt a wait-and-see stance to gauge the sustainability of the nascent economic recovery. Nevertheless, the three-year benchmark yields have been reacting to higher rate expectations, trading above the 3% mark since last December.

Should the central bank raise rates by a minimal quantum, Wan Murezani says the impact on yields will not be significant given that the short-end of the curve has already climbed by more than 20 bps and the spread between the three-year and OPR is already wide by normal standard. On the other hand, if the quantum of rate hike was higher, investors can expect to see the yield curve flatten with the short-end rising at a faster rate.

In the event of a rate hike, AmBank’s Wan adds that the downside risk on yields will also be capped by the subdued outlook on inflation. This is due to the uncertainty surrounding the restructuring of government subsidies. Nevertheless, if inflation is high, some pressure on the yields curve is expected, she adds.

On the whole however, she does not think yields will go up significantly as the market has already priced in some of the negatives. 

MARC’s Wan Murezani says the overall strategy for a fixed income fund manager is to lower the portfolio duration to lower the sensitivity to a rising rate scenario, get cash back faster and reinvest at a higher rate.

In view of the impending rate hike cycle, AmBank credit research is advising clients to maintain a neutral portfolio duration for attractive yield pick-up. It is also promoting a strategy of investing in private debt securities (PDS) further down the credit curve to drive portfolio returns.

“The market is hungry for yields nowadays because of high cash holding and low prevailing yields in the market. In this environment, papers with double-A rating and below may see rising scarcity value given the lack of supply in this segment. The strategy we are advocating is to go down the credit curve to selectively go for more credit exposure,” Wan explains.   

Wan Murezani adds that if a rate hike comes sooner rather than later, it is an indication of the authorities confidence in the economic recovery. Hence PDS should outperform the govvies.

“This will be a good time for investors to hunt for higher yields in credit. The triple-As credit is already in expensive territory in our assessment on credit spreads but there is still value in the double-As,” he says.

However, investors still need to be selective as “tail risk” still remains for some issuers as the negative credit quality implication due to difficult operating environment arising from the recent recession has been significant.

This article appeared in Corporate page, The Edge Malaysia, Issue 791, Feb 1-7, 2010