The rally in ringgit-denominated Islamic bonds that pushed yields to an eight-month low will end after the central bank ruled out a cut in interest rates, according to CIMB Group Holdings Bhd and RHB Capital Bhd.

Yields may rise after Bank Negara Malaysia Governor Zeti Akhtar Aziz said in an interview in Kuala Lumpur this week that the benchmark policy rate of 3 percent is supportive of economic growth ahead of a March 9 review, RHB Capital and CIMB say. Yields on 3.505 percent notes due in September 2014 dropped for a third month in February and have fallen 32 basis points to 3.15 percent from a June 30 peak, according to Bursa Malaysia prices.

"There's pressure for sukuk yields to go up due to lower rate-cut odds," Suzaizi Mohd Morshid, head of treasury at Kuala Lumpur-based RHB Islamic Bank Bhd, a unit of RHB Capital, said in an interview yesterday. "Islamic bonds are less liquid and investors tend to cash out of them first before conventional debt."

Overseas funds reduced holdings of local-currency government Islamic bonds by 11 percent in January to RM490 million (US$163 million), the least in a year, data on the central bank's website showed. One-year interest-rate swaps have risen to a three-month high to yield 15 basis points more than Malaysia's policy rate, signaling traders are starting to factor in higher borrowing costs in the coming year.

Demand at an auction of sukuk, which pay returns on assets to comply with Islam's ban on interest, fell this week, according to Bank Negara data. The Southeast Asian nation's government sold RM3.5 billion of notes maturing in August 2017 at an average yield of 3.309 percent on Feb. 28, with investors bidding for 2.3 times the amount for sale, the lowest ratio this year. -- Bloomberg