by Jake Maxwell Watts
Wall Street Journal
April 19, 2016

The cost of insuring five-year Malaysian government bonds rose to $164.20 on Tuesday

SINGAPORE—The cost of insuring against losses on Malaysian government bonds rose Tuesday on concerns that the national government could be on the hook for billions of dollars of debt owed by state development fund 1Malaysia Development Bhd.

The state fund, which is the focus of corruption probes in at least seven countries, has almost $13 billion in debt it is struggling to repay. 1MDB has denied wrongdoing and says it is cooperating with investigations.

A dispute made public this week between 1MDB and the Abu Dhabi guarantor of some of its debt, International Petroleum Investment Company, has put the future of a debt-workout agreement in doubt and in turn has shaken investors who fear the Malaysian government may need to step in.

The cost of insuring five-year Malaysian government bonds rose to $164.20 on Tuesday, up from $160.18 at Monday’s close and 9.7% more expensive than at Friday’s close before the dispute became public. The bond prices themselves were little changed, with the five-year yield at 3.42% on Tuesday, from 3.41% a day earlier.

Japanese brokerage Nomura said Tuesday it was turning negative on Malaysian credit, lowering its recommendation to below the market average from “neutral,” partly due to “further concerns around the finances of 1MDB.”

The dispute between 1MDB and IPIC is over a 2012 debt-restructuring agreement struck between the two sovereign funds in which IPIC guaranteed $3.5 billion of 1MDB’s bonds. It later also granted an emergency billion-dollar loan to 1MDB and pledged to continue making interest payments on the same bonds it had guaranteed. In return for IPIC taking over the debt, 1MDB agreed to transfer undisclosed assets to the Abu Dhabi fund, according to stock-exchange filings.

On Monday, IPIC said 1MDB had broken the terms of its arrangement by failing to pay $1.1 billion due to it by the end of last year in return for IPIC taking on 1MDB’s debt. It said the debt deal between the two entities had been terminated, and that it considers both 1MDB and Malaysia’s Finance Ministry to be in default and it is considering options including referring the matter to the “appropriate dispute resolution forum.”

In response, 1MDB said Monday it had met the terms of the deal. It said it had offered to make the transfer of assets stipulated in the agreement in the form of fund units in an offshore company it controlled. 1MDB also said a $50 million interest payment due Monday from IPIC on the $3.5 billion of debt it had guaranteed wasn’t paid.

The Wall Street Journal reported Monday, citing a memo sent last week from 1MDB to the Malaysian Ministry of Finance, that Malaysia could make the payment on behalf of 1MDB, but doing so would harm its negotiating position with IPIC.

1MDB didn’t respond to an emailed request for comment on Tuesday. In a statement made on Bloomberg television, the fund’s president, Arul Kanda, said the company expected an “amicable resolution” to the dispute with IPIC and that 1MDB would be able to cover short-term interest payments on its bonds even if IPIC didn’t.

As part of the 2012 agreement, 1MDB and Malaysia’s Finance Ministry agreed to indemnify IPIC for any nonperformance of the debt it took on, meaning that if 1MDB failed to make repayments of the debt principal, the government would need to step in. The statement on the debt-settlement arrangement, made to the London Stock Exchange, didn’t elaborate on how this indemnity may work.

Analysts said they still expected IPIC to honor its guarantee of the 1MDB bonds.

“We still believe that the original guarantee provided by IPIC for this obligation is still intact,” said Christian de Guzman, vice president and senior analyst at Moody’s Investors Service, which rated $1.75 billion of the $3.5 billion dollars involved in the restructuring agreement. But, he added, “there is much uncertainty about what that entails.”

He said there was a grace period of five days from Tuesday, during which time the $50 million overdue interest payment could still be paid.

In January, Moody’s maintained its A3 rating on Malaysia’s government bonds but lowered its rating to “stable” from “positive” due to deteriorating economic growth, high leverage across Malaysian markets and an expectation that the government’s debt burden will improve, though slowly, in the longer term.

Malaysia’s ringgit surged in Tuesday’s session, contrary to moves in the cost of insuring Malaysian government bonds. The U.S. dollar weakened 1.2%, with one dollar buying 3.88 ringgit, from as many as 3.95 ringgit at Monday’s close.

“The Malaysian ringgit, and markets in general, seem to be operating on something other than logic right now. However, I can’t see how this [disagreement between IPIC and 1MDB] is anything but negative for it, and for sentiment towards Malaysia,” said Michael Every, head of financial markets research for Asia at Rabobank in Hong Kong.

To be sure, some investors say the market has become numb to negative news on 1MDB, after a long-running saga that dates back well over a year. “We think the market will give Malaysia the benefit of doubt and this will not affect Malaysia’s sovereign debt,” said Edmund Goh, an investment manager for Aberdeen Asset Management. “It’s a serious issue, but we investors [think] so long as [Malaysian Prime Minister] Najib [Razak] can keep power he will resolve this,” he said.

—Jasper Moiseiwitsch contributed to this article.