● On 29th March, FTSE Russell removed Malaysia from its Watch List for potentialexclusion,keepingMalaysian bonds includedin the FTSE World Government Bond Index (WGBI)

- Following its inaugural fixed income country classification review in April 2019, FTSE Russell announced that Malaysian debt may be excluded from the WGBI, as the country failed to meet the necessary market accessibility thresholds. Malaysian bonds were put under a Watch List for two years whilst FTSE Russell periodically reviewed the initiatives Malaysia deployed to improve market conditions.

- When finally removing Malaysia from the Watch List, FTSE Russell commended Bank Negara Malaysia (BNM) for the various initiatives implemented to address the concerns of foreign investors. These initiatives broadly improved the domestic financial markets’ liquidity, structure, and accessibility:

▪ BNM enhancedsecondary market bond liquidity by increasing the number of re-openings among MGS issuances in 2021 to 19 (2020: 15; 2019: 16), allowing for more MGS to be available via repurchase agreements, introducingphysical settlements for MGS futures, and consolidating the number of bond issuances to increase the outstanding size per issuance.

▪ The Appointed Overseas Office (AOO) programme, created in 2016 to enhance liquidity of the FXmarket, wasfurther developed to increase price transparency after local trading hours.

▪ The Dynamic Hedging Programme, introduced in 2016 and allowing non-resident investors to actively manage their FX exposures onshore, was expanded to include trust banks and global custodians, which permitsthem to hedge on behalf of their clients. Additionally, the FX documentation and due diligence process was streamlined, making the market more accessible.

▪ Earlier this month, BNM alsoannounced that non-resident banks would be allowed to trade ringgit-denominated interest rate swaps (IRS) with any onshore bank or AOOs without underlying commitment. This move would facilitate foreign banks to participate in the onshore IRS market, whilst enhancing liquidity and lowering hedging costs.

● Chinese Government Bonds (CGB) willnowbeaddedintothe FTSE WGBI, with inclusion to be phased-inovera 36-month period starting October 2021

- Following two years on the Watch List for potential inclusion, the market accessibility level of China has been upgradedamid variousmarket enhancements. As such, considering the assets-under-management (AUM) tracking the WGBI and China’s purported weightage, the world’s second-largest economy is projected to receiveforeign inflows of around USD130.0b.

- Additionally, FTSE Russell has now placed India and Saudi Arabia on the Watch List for potential upgrade, which may lead to their inclusion into the WGBI in the future.

● FTSE Russell’s decision may lift demand for MGS in the short-term, causing yields to fall, even whilst supporting foreign fund inflows in the long-term

- Estimating that there is USD2.5t worth of AUM currently tracking the WGBI and accounting for Malaysia’s current Index weightage of 0.39%, projected total funds of USD9.75b (RM40.48b) are now secured against immediate risk of capital flight, equivalent to 9.10% of total outstanding MGS and 22.1% of total foreign holdings of MGS.

- However, China’s inclusion in the WGBI will dilute the weightage of Malaysia’s and other countries’ bonds in the Index. FTSE Russell states that China will hold a weightage of 5.25%, which will marginally reduce Malaysia’s weight by 2bps to 0.37% (amounting to a possible USD0.5bforeign outflow), and significantly lower the weightage of U.S. bonds by 194bps to 34.94%. Nevertheless, this process will only begin from October and will have a relatively long phase-in period of 36 months, which should help stem the effect of foreign fund outflows as the new weightage takes effect.

- Since FTSE Russell’s announcement on the 29th of March, demand for MGS has already improved with the 10Y MGS yield falling 3.9bps to 3.28%as at 30th of March. Considering that MGS yields had already begun decreasing last week, tracking a fall in United States Treasury yields, we expect MGS yields to continue declining in the short-term.

- Additionally, foreignfund inflowsmay increase in the near-term on the back of FTSE Russell’s decision, however downside risks remain amid a rise in risk-off sentiment, as a number of EU countries return to COVID-19 related lockdown.Nonetheless, in the long-term we expect net foreign inflows to persist as high yield differentials keep Malaysian bonds attractive even as investors exit from U.S. and other bond markets during this period of heightened yield volatility.

Source: Kenanga Research - 31 Mar 2021