KUALA LUMPUR (BLOOMBERG) - Malaysia paid a bigger premium to bondholders to own some of its new Islamic debt as a delayed interest payment by its troubled state investment fund weighed on demand.

The government priced US$1 billion of 10-year notes at a wider spread than an offering a year ago. The sale, which also included US$500 million of 30-year notes, drew US$6.3 billion of orders, compared with US$9 billion for an issuance of the same size in April 2015.

Malaysia warned investors that it faces as much as US$4.5 billion in potential liabilities as government investment company 1Malaysia Development Bhd. remains locked in a dispute with Abu Dhabi's sovereign wealth fund over debt obligations. The disagreement has led to a delay in an interest payment of US$50 million on 1MDB bonds, hurting confidence in the sovereign just when the outlook for the oil exporter was improving amid a stabilization in crude and strength in the ringgit.

"The 1MDB risk might have spooked investors' sentiment this round as it reemerged when the deal was about to close," said Fakrizzaki Ghazali, a Kuala Lumpur-based strategist at RHB Research Institute Sdn.

Abu Dhabi's International Petroleum Investment Co (IPIC) entered an agreement with 1MDB in May 2015 to provide the latter with cash to settle some liabilities in exchange for a transfer of assets, as well as assume interest obligations on US$3.5 billion of debt. The failure to repay the loan of US$1.1 billion means 1MDB and its sole shareholder, Malaysia's finance ministry, are effectively in default, IPIC said in a stock exchange filing last week.

The government addressed its potential liability in the 1MDB-IPIC dispute in the sukuk offering document. If 1MDB is unable to make payments as they fall due, "the government does not believe that any amounts that it would be required to pay with respect to the indebtedness of 1MDB would be material to the government."

1MDB's President Arul Kanda said in an interview with Bloomberg on Tuesday that he sees an "amicable resolution" with IPIC. It remains unclear who will honor the interest payment that was due on Monday and has a five-day grace period.

While Malaysia paid a bigger premium over US Treasuries for the 10-year bonds, the spread was narrower on the 30-year debt compared with the 2015 issuance. The sukuk due in 2046 was sold at 4.08 per cent, a premium of 145 points versus 170 previously. Those due in 2026 sold at 3.179 per cent, a spread of 135 basis points compared with last year's 115 points.

"Market sentiment in the Asian dollar credit space is still marginally positive," said Winson Phoon, a fixed-income analyst at Maybank Investment Bank Bhd in Kuala Lumpur. "The recent negative news flow is seemingly a replay of what happened a few months back and this time round it doesn't seem to have impacted negatively on the pricing for this sukuk."

The funds raised will partly be used to refinance US$1.2 billion of Islamic bonds maturing in July. Malaysia's existing 10-year sukuk, sold in April 2015 at a coupon of 3.043 per cent, yielded 3.04 per cent on Thursday, while the 4.236 per cent securities due in 2045 were paying 3.97 per cent, data compiled by Bloomberg show.

For the 10-year sukuk, 65 per cent was taken up by investors in Asia, 19 per cent from the Middle East, 11 per cent in Europe and 5 per cent in the US, according to an e-mailed statement from the finance ministry. About 54 per cent of the 30-year debt was distributed to Asia, 12 per cent to Europe, 24 per cent to the US and 10 per cent to the Middle East.

"We are pleased with the investors' response and confidence in Malaysia's credit standing," Mohd Irwan Serigar Abdullah, Secretary General of Treasury at the Ministry of Finance, said in the statement. "This is a remarkable achievement as demonstrated by the tight pricing and excellent response on this landmark sukuk."

While sentiment for the ringgit improved, the cost to insure the nation's sovereign bonds increased this week as the saga over 1MDB took on a new twist. The government's debt is rated the fourth-lowest investment grade by all the three major ratings companies.

Five-year credit-default swaps on Malaysia's sovereign debt climbed to a six-week high of 168 on Wednesday, according to CMA prices. The contracts rose above 245 in September, the highest in more than six years.