China's New Bond Rules Seen Threatening Losses for Yield Hunters

China’s plan to tighten rules governing the use of corporate notes as collateral for short-term loans is fueling concern that yield hunters may face losses.

China Securities Depository and Clearing Corp., which oversees notes in the nation’s smaller exchange-traded market, plans to allow financial institutions to use only AAA rated company securities as collateral for short-term loans, people familiar with the matter said Tuesday. The plan will make bonds rated below that level less liquid, likely driving up yield premiums, according to analysts at Guotai Junan Securities Co. and SWS Research Co.

China’s stabilizing economy has given policy makers an opportunity to try to curb leverage in the debt market to rein in financial risks. That’s become all the more imperative amid attempts to limit the fallout from rising failures. At least eight onshore bonds defaulted this year following 29 failures in 2016. While recent investor caution on leverage could lessen short-term impacts, the new rules are likely to be felt longer term, according to Guotai Junan.

“In the medium to long term, yield spreads for bonds of various tenors and ratings will rebound from recent low levels,” analysts Qin Han and Liu Yi at Guotai Junan wrote in a Wednesday note. “Investors will ask for a higher liquidity premium for lower-rated bonds and those notes will likely see spreads widen.”

While the smaller size of the exchange-traded market -- 5.5 trillion yuan ($799 billion) compared with 58.2 trillion yuan in the interbank market -- could also limit the impact, any jump in financing costs would present a setback for many of the nation’s smaller borrowers. The absolute yields on all bonds have already shot up his year, and the rate on AA- rated notes due in five years rose 3 basis points Tuesday, the most in more than a week, to 6.44 percent.

But riskier firms have fared better this year than their top-rated peers, as investors who had been spooked by fraud cases in the debt market at the end of last year ventured back to them. The premium on AA- rated notes over AAA graded securities has dropped 18 basis points this year to 195 basis points, the lowest since 2014.

Bonds issued after April 7 that are rated AA+ and below will not qualify for use as collateral, the people familiar with the matter said Tuesday, asking not to be identified as they weren’t authorized to speak publicly. The new rule won’t apply for notes sold before April 7, they said. Under the current rule, securities with ratings of AA or higher are eligible as collateral.

CSDC didn’t respond to a fax seeking comment.

— With assistance by Lianting Tu, and Ling Zeng