A recent announcement by Chinese regulators to tighten the rules surrounding the use of corporate bonds as collateral should help reduce systemic risks, but it is also a credit negative for onshore issuers and borrowers. The rule changes effectively reduce the pool of bonds eligible to serve as collateral for repurchase agreements or repos, which should curb the growth in system-wide leverage that the rapid development of the repo market has helped engender, according to a new Moody’s Investors Service report.
“The new rules are aimed at controlling leverage in China's financial markets and should therefore reduce systemic risks,” said Nino Siu, a Moody's vice president and senior analyst. “And, by restricting the use of collateral to high-quality bonds, the new rules reduce the likelihood that defaults on lower-rated bonds could bring about a rapid contraction in the supply of credit, in the event that they cause lenders to reassess the risks of collateralized lending.”
On April 7, the China Securities Depository and Clearing Corporation Limited (CSDC) announced that, starting April 8, only newly issued corporate bonds with onshore issuer ratings/bond ratings of AA/AAA, AA+/AAA and AAA/AAA can be used as collateral in a repurchase agreement. Bonds issued or announced with a prospectus on or before April 7 are not affected by the new rules.
This change should enhance the regulation of the credit risks in the repo market that has more than doubled since March 2015 to about $3.25 billion by the end of this March, analysts said. About 34% of all corporate bonds in the onshore exchange-traded market in China are AAA-rated by onshore rating agencies. That means borrowing on the remaining lower-tier bonds available in the onshore market will become more difficult. Also, more borrowers tend to look for non-AAA-rated bonds at the short end of the duration curve. “The loss of repo eligibility for non-AAA-rated bonds will therefore boost the liquidity premium of such corporate bonds and result in a wider yield differentiation between AAA and non-AAA-rated bonds, raising funding costs for lower-rated issuers,” Moody’s said.
– Nicholas Stern, senior editor