Probe Risk Sends AAA Spreads to Three-Month High: China Credit

Borrowing costs for top-rated Chinese companies rose to a three-month high as the central bank’s probe into the $3.7 trillion interbank bond market drove investors into safer government securities.

The People’s Bank of China asked market participants to examine trading histories as it cracks down on short-term transactions designed to bypass month-end risk evaluations, two people with knowledge of the matter said this week. The extra yield on 10-year AAA bonds over sovereign debt climbed to 172 basis points yesterday, the highest since Jan. 22, ChinaBond indexes show. The comparable U.S. gap is 83 basis points, according to Bank of America Merrill Lynch indexes.

The investigation will force some investors to cut their bond investments as they can no longer ask others to hold the debt during regulatory reviews, according to Bank of America Merrill Lynch and Guotai Junan Securities Co. That may damp demand just as Premier Li Keqiang seeks to spur fundraising to revive the world’s second-biggest economy. Manufacturing unexpectedly slowed this month, data indicated this week.

“The bond market investigation is intensifying,” Ethan Mou, a rates strategist at Bank of America Merrill Lynch in Hong Kong, said in an email interview on April 25. “Many small banks, securities companies and funds are de-leveraging their credit holdings due to fear of exposure.”

Accounts Freeze

China suspended opening of new bond accounts in the interbank market by trusts and brokerages’ asset management units, the Shanghai Securities News reported yesterday, citing unidentified people. ChinaBond, the nation’s biggest debt clearing house, has also stopped account opening for mutual funds’ client trading departments, the Chinese-language newspaper reported. The central bank has temporarily stopped accepting account applications, it added.

Some financial institutions, seeking to move bonds off their balance sheets, have asked other institutions to hold the securities for them over a certain period in return for a fee, according to an April 22 China National Radio article.

Interest payments and gains from any price appreciation continue to belong to the original owner, according to the article. Because such transactions are outside of regulated markets, they open the door to abuses like insider trading and the use of client funds for trades generating personal gains, China National Radio said.

‘Illegal Transactions’

China should establish a unified and effective monitoring mechanism to stop “illegal transactions” in the market, China Securities Journal said in a front-page editorial yesterday.

The average yield on 10-year top-rated corporate bonds in China has climbed three basis points this week to 5.15 percent as of April 25, according to ChinaBond data. That’s the highest level since April 9. The rate on similar-maturity government bonds fell two basis points to 3.43 percent.

“The AAA-rated bonds are facing selling pressure because some institutions will have to unload certain holdings amid the probe,” said Yang Kun, a Shanghai-based analyst at Guotai Junan Securities Co., in an April 24 phone interview. “Given the AAA bonds have good liquidity, they therefore will be selected to sell.”

The cost to insure sovereign notes from Asia’s largest economy was unchanged this week. Five-year credit-default swaps closed at 72 basis points yesterday in New York, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.

Foreign Funds

China opened its interbank bond market, which trades over 90 percent of the nation’s debt, to qualified foreign institutional investors last year. Australia’s central bank announced plans this week to invest about 5 percent of its foreign-exchange reserves in China, a move Commonwealth Bank of Australia estimated would lead to as much as A$2.4 billion ($2.5 billion) switching into the yuan and domestic government bonds.

Global yuan usage increased 33 percent in March from the previous month and the currency ranked the 13th in terms of international payments, Society for Worldwide Interbank Financial Telecommunication said yesterday. The yuan rose 0.12 percent to 6.1630 per dollar in Shanghai today, when it touched a 19-year high of 6.1616.

The probe will help boost confidence of foreign investors in China’s markets, even though it could stir skepticism in the short term, according to Banny Lam, the Hong Kong-based co-head of research at Agricultural Bank of China International Securities Ltd., a unit of the nation’s third-largest lender.

Market Transparency

“China’s bond market has grown rapidly in recent years and there’s room for improvement in regulations,” Lam said by telephone yesterday. “The investigation shows the leadership is determined to improve the market’s transparency. That’s also important to yuan internationalization. You do wish to have things more regulated as significant players like the Australian central bank are about to join.”

Slowing economic growth could boost demand for bonds as Chinese stocks head for a third monthly decline. Gross domestic product increased 7.7 percent in the first quarter from a year earlier, compared with 7.9 percent in preceding three months. The preliminary reading of 50.5 for an April purchasing managers’ index released by HSBC Holdings Plc and Markit Economics this week fell short of the median 51.5 estimate in a Bloomberg survey.

“The latest economic data showed China’s economy is not as strong as the market estimated,” said Xie Jun, a Guangzhou-based fund manager at GF Fund Management, in a phone interview yesterday. “This is a positive factor for the bond market.”

Fitch Downgrade

Fitch Ratings Ltd. cut China’s long-term local-currency debt rating on April 9, citing rising risks to the country’s financial stability given the lack of transparency in the increased borrowing of local governments. The entities may have had 12.85 trillion yuan ($2.1 trillion) of debt at the end of last year, equal to about 25 percent of GDP, Fitch said.

“The regulators are on top of the issue, and working to try to limit the risk,” said Mou of BofA Merrill Lynch. “One measure they are doing is to direct some of the shadow banking financing towards the bond market, so that bond supply will continue to stay high going forward, ultimately putting some upward pressure on credit spreads and yields.”

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