This article first appeared in The Edge Financial Daily, on April 27, 2016.

KUALA LUMPUR: 1Malaysia Development Bhd (1MDB) has defaulted on the US$50.3 million (RM197.98 million) interest payment due to its US$1.75 billion bonds issued by its unit 1MDB Energy (Langat) Ltd.

This probably marks the largest default made by a state-owned company, with debts bearing a letter of support from the government.

Consequently, 1MDB in a statement said a cross default had been triggered on an RM5 billion sukuk, which is due in 2039, and the RM2.4 billion Bandar Malaysia Sdn Bhd sukuk (due between 2021 and 2024).

But there is no cross default on the RM800 million loan from the Social Security Organisation, according to 1MDB.

“1MDB wishes to underline that it is committed to working openly with IPIC (International Petroleum Investment Co) to resolve the dispute in order to minimise the impact on all stakeholders and to avoid the need for accelerating bond or sukuk payments in a way that would pose significant risks to its rationalisation plan,” the statement read.

1MDB could be on the verge of insolvency, should the sukuk holders demand for an early redemption of the debt papers.

However, the sukuk holders are not expected to call for accelerated principal recovery. This is simply because of the government guarantee which has given them peace of mind.

“The [RM5 billion] sukuk is government-guaranteed. 1MDB’s name may be on the bonds but the way it is wrapped, it is as good as MGS (Malaysian Government Securities). There is no reason for us to disturb the bonds. We have already decided to vote against accelerating,” explained one fund manager who is holding the sukuk.

AmInvestment Bank Bhd is said to be one of the major holders of the bonds, as it was the arranger and sole off-taker of the RM5 billion sukuk that was issued in 2009.

The financial markets were virtually unaffected by the default, other than a 3.53% uptick in Malaysian 10-year credit default swap (CDS) spreads to 216.35 basis points (bps) yesterday. Note that CDS spreads are 29% lower than its peak of 308.48bps in September last year, but still 21.85% higher than it was a year ago.

The higher the CDS spreads, the more expensive the cost to protect Malaysian sovereign notes.

After all, the US$1.75 billion bondholders will still be paid. Abu Dhabi’s IPIC has said that it will make the interest payment under its obligation as co-guarantor for the bonds. The payment should be made within 10 business days from the original payment deadline, April 18, as per the terms of the guarantee. Hence, IPIC should pay bondholders by May 2.

IPIC is also the co-guarantor for another US$1.75 billion bond, issued by 1MDB’s wholly-owned 1MDB Energy Ltd, that is due in 2022 (1MDB-Energy Notes). 1MDB, however, clarified that no cross default was triggered on this bond.

The default stems from disputes between 1MDB and IPIC, which claimed that it did not receive any money as a form of indemnity to guarantee the US$3.5 billion bonds issued by 1MDB. However, 1MDB said it transferred US$3.5 billion to  a British Virgin Islands-registered firm called Aabar Investments PJS Ltd (BVI), a company that IPIC recently clarified was not a unit of the sovereign wealth fund.

1MDB president and chief executive officer Arul Kanda Kandasamy has stressed that 1MDB’s RM2.3 billion cash reserve is ample liquidity to service the interest payment.

Technically, the Langat bondholders still have the right to trigger an event of default and call for accelerated principal recovery. 1MDB does not have the liquidity to meet such a claim and may well have to rely on its co-guarantor, IPIC.

In practice, however, the bondholders are highly unlikely to do so because their “cause for action”, the interest default, will be cured by IPIC’s payment even if it is a little delayed, explained a source with knowledge of the matter.

“Bondholders will also think twice about acceleration when they are dealing with a company which is not readily available to repay the debt in full. Such acceleration action may result in the debtor going for voluntary bankruptcy and creditors have to stand in line for their claim, unlikely to get 100 cents back on the dollar,” the source explained.

Going ahead, however, 1MDB still need to find a solution to rationalise its debts. The US$3.5 billion dollar-denominated bonds that are guaranteed by IPIC have a projected cash cost of RM17.313 billion for interest and principal till maturity in 2022, according to the Public Accounts Committee report on 1MDB.