KUALA LUMPUR (April 30): DBS Group Research has downgraded Malaysian government debt papers, noting that the valuations of Malaysian Government Securities (MGS) are no longer as cheap and "the risks around performance have risen considerably".

In today's research report, DBS Group's analyst Duncan Tan commented that the elevated uncertainties and risks around future developments and outcomes would likely see MGS and ringgit trade more volatilely ahead.

The research firm has changed its stance on Malaysian government debt papers from "bullish" to "neutral".

Tan added that it would be prudent not to discount the possibility of an extended selloff should MGS holders decide that event risks are too high to bear.

He highlighted the risks are that Norway's sovereign wealth fund is expected to cut emerging-market debt, including Malaysian securities, from its index, and stock market indices provider FTSE Russell has placed Malaysia on its "watch List of fixed income" markets that will be reviewed for potential changes to their market accessibility levels.

"In aggregate, US$11 billion (RM45.50 billion) of potential outflows (expected US$2 billion [from Norway's sovereign wealth fund] and possible US$9 billion [from FTSE Russell]) which represents approximately 7% of outstanding and 27% of current foreign holdings," DBS Group said.

The research house said it has been seeing weakening ringgit against the greenback coincide with falling forward points and the base for both currencies' exchange rate have widened. It attributed this to foreign holders unwinding foreign exchange hedges alongside their bond sales.

Therefore, the research house expects the strong bond inflows of February and March to reverse in April.

"Our base case is that Norway's sovereign wealth fund would sell its holdings in a very gradual manner, to limit the market impact and get the best possible price.

We also expect Malaysia's regulators to be in constant engagement with FTSE Russell to address issues and avert an exclusion decision at the September review (we think a retain decision is most likely)," said DBS Group.

In terms of MGS valuation, DBS Group said there appears to be limited scope for further capital gains mainly as Bank Negara Malaysia's (BNM) easing cycle is likely to be shallow and a cut at the May or July meeting has already been priced in.

"Earlier in the year, we had expected compression of credit risk premium (as fiscal concerns ease) to drive much of the price appreciation. That has since been largely realised with five-year CDS (credit default swap) spreads falling from 110 to 55bps.

From this point on, much lower MGS yields are unlikely unless global core yields fall (we expect core yields to be rangebound with slight upward bias). Ultimately, the reward-risk proposition of MGS is much less attractive when compared to the start of the year," it added.