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Malaysian sukuk curve steepens as inflation adds to outflow risk

The Petronas Towers, center, stand in the central business district in Kuala Lumpur, Malaysia.

[KUALA LUMPUR] Malaysia's Islamic bond investors are fleeing longer-dated sukuk as accelerating inflation adds to the risk of outflows amid a global emerging-markets selloff.

The difference in yields between 2025 Shariah-compliant securities and three-year debt widened 14 basis points this year to average 67 in August, the most since May 2014. Data last week showed July's inflation rate was the highest in 11 months, while foreign ownership of bonds in Malaysia fell to the lowest since 2012.

Longer-dated borrowing costs will rise further as the Federal Reserve prepares to raise interest rates, CIMB Group Holdings Bhd and Asian Finance Bank Bhd. predict. Offerings of Islamic bonds in Malaysia dropped to a five-year low in 2015 as an 18 per cent plunge in the ringgit and a collapse in oil prices made it hard to gauge earnings prospects.

"Investors are shortening their duration ahead of the Fed's rate hike,' said Nik Mukharriz Muhammad, a Kuala Lumpur- based fixed-income analyst at CIMB Investment Bank Bhd, a unit of Malaysia's second-biggest lender by assets. ''The fall in the currency, oil prices and the political concern in the country are also not helping."

Yields on 10-year ringgit-denominated Shariah-compliant notes climbed 16 basis points this year to 4.43 per cent, near the record 4.44 per cent reached in December 2013, while those on three-year sukuk increased two basis points to 3.77 per cent, Bank Negara indexes show. The gap between the two is sometimes referred to as the yield curve and the difference for conventional debt has averaged 78 basis points in August.

Higher borrowing costs have led to reduced sukuk issuance by Malaysian companies. Offerings of securities that pay returns on assets to comply with Islam's ban on interest fell 27 per cent to 30.1 billion ringgit so far in 2015, data compiled by Bloomberg showed. That's the least since 2010 when sales were 11 billion ringgit at this stage of the year.

Consumer prices climbed 3.3 per cent in July from a year earlier, more than the median 2.9 per cent predicted by economists in a Bloomberg and the 2.5 per cent in June. Malaysia's central bank forecast in March that inflation would average 2 per cent to 3 per cent in 2015.

Overseas investors cut holdings of sovereign and corporate notes by 2.4 per cent in July to 206.8 billion ringgit (S$68.6 billion), official data show. They reduced the amount of Islamic sovereign notes they hold to 8.2 billion ringgit, from 9.8 billion in June and a record 10.9 billion in May.

The pullout by foreign investors is contributing to the pickup in yields, Norlia Mat Yusof, chief investment officer at Kuala Lumpur-based Etiqa Insurance & Takaful, said last week.

"We have been gradually reducing our position in sukuk that are more than 10 years because we expect yields to rise further," Zulkiflee Mohd. Nidzam, head of foreign exchange and bond trading at Kuala Lumpur-based Asian Finance Bhd said Friday. "The odds that Malaysia's central bank will follow the Fed in raising interest rates are high." Malaysia's economy has come under pressure as Brent crude prices that have more than halved from their 2014 peak weigh on earnings for Asia's only major net oil exporter. Gross domestic product expanded 4.9 per cent in the three months through June, the slowest pace since the third quarter of 2013. The central bank has kept its benchmark policy rate at 3.25 per cent for the past year, refraining from joining a global wave of easing to boost growth.

A political scandal involving transfers of cash to the personal bank accounts of Prime Minister Najib Razak have also fueled the selloff. The Malaysian Anti-Corruption Commission is continuing a probe into the payments, which it said this month were donations in 2013 from the Middle East.

The country's foreign-exchange reserves dropped 19 per cent this year to US$94.5 billion as of Aug 14, the least since 2010. The cost to insure government debt has climbed this year above that for Thailand and the Philippines and reached the highest since 2011, CMA prices show.

"There is more room for the Islamic bond yield curve to steepen," said James Lau, a Kuala Lumpur-based investment director at Pheim Asset Management Asia Bhd, overseeing US$300 million. "The weakening ringgit and the accelerating inflation will add to the case for a rate increase. That's why people are avoiding longer-dated paper."