China Securities Depository and Clearing Corp (CSDC) said in an announcement after the market closed on Monday that with immediate effect, only corporate bonds with the highest rating of AAA and those issued by firms with a high rating of AA and above could be used for bond repo business.
Analysts say the regulators' exclusion of lower grade bonds from being used in bond repurchase contracts, a key source of secondary liquidity in trade, increases the risk of trading such bonds, depressing demand and putting upward pressure on yields.
The move follows through on a decree issued by the State Council, China's cabinet, in early October to clear debt issued by local government financial vehicles (LGFVs), even though the CSDC's ban apparently covers a wider range of corporate bonds, the announcement shows.
"Along with the clarification and clearing of local government debt, our company could take further steps to compress and clear related bonds already being included in the collateral in line with market risk conditions," the announcement said.
Given that more than 1 trillion yuan of outstanding corporate bonds are now deposited at the CSDC, analysts estimate that around 500 billion yuan of the bonds will be excluded from the repo business starting Tuesday, with the yields of credit bonds possibly being pushed up by a few dozens of basis points as their prices fall.
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"This is bound to have a major impact on the bond market," said a dealer at a Chinese commercial bank in Shanghai.
"The Shanghai Stock Exchange's bond market will be hit the most as China's corporate bonds are concentrated in the stock exchanges, although the move is likely to spill over to the main interbank bond market as well to a lesser extent," he said.
In an earlier follow-through step of the cabinet decree, the Ministry of Finance issued in late October new rules to accurately assess the amount of debt outstanding at the local government level by the end of the year.
Chinese authorities are struggling to manage a massive $3 trillion in outstanding local government debt, much of it raised by LGFVs to finance infrastructure and real estate projects during the global financial crisis.