(Yicai Global) July 20 -- China's bond market has rallied late this week after the central bank issued window guidance to domestic financial institutions, encouraging them to subscribe to lower-rated credit bonds to ease financing woes at small- and medium-sized enterprises.

One joint-stock bank got the note from the People's Bank of China late on July 18, encouraging the lender to increase holdings in bonds issued by industrial firms with a credit rating below AA+, a source from the bank's financial market department told Yicai Global. Other sources from joint-stock and commercial banks and non-banking financial institutions confirmed receiving the same guidance.

Local government-endorsed municipal investment bonds reaped the biggest gains, but institutional investors are still cautious about the privately issued pledges.

The MIBs, also known as quasi-municipal bonds, are publicly offered corporate bonds and medium-term bills issued by local government-owned investment and financing platforms that specialize in local infrastructure construction or public welfare projects. Most subscribers regard them as bonds issued by local governments, though the authorities themselves are not allowed to issue bills.

Sources from several non-banking financial institutions told Yicai Global their firms had bought bonds rated lower than they would usually buy -- mostly AA+ and AA rated quasi-municipal bonds. The municipal bills are generally seen as being a safer bet than bonds from other private companies.

Boosting the Middle

The central bank's suasion will mostly boost performance of low- and medium-rated credit bonds, those rated AA in particular, said Zheng Lianghai, a fixed-income analyst at Caitong Fund Management. Underpriced bonds with solid fundamentals on the secondary market will likely see price rebounds, he added, but said most institutions prefer quasi-municipal bonds and those offered by companies with higher credit ratings -- so those will stay on top of the market.

"The window guidance was good news for the low- to mid-rated municipal investment bonds, but they still involve risk," an investment research head at a commercial bank said. "The risks posed by the substantial share pledges made by major company shareholders are still prevalent, so investors are cautious about private enterprise bonds."

"Liquidity on the interbank market isn't tight at the moment," added Lou Chao, a bond portfolio management at UBS Asset Management Shanghai. "The cost of borrowing money for 91 days is typically less than 3.3 percent, but the costs to institutions of obtaining central bank funding to act on the window guidance are not so low. PBOC may need to provide further incentives to arouse institutions' interest in low-rated bonds."

Institutional investors are holding back on the bonds rated less than AA+, and their primary targets are still interest rate bonds, certificates of deposit and better-rated credit bonds. Investment consultancies raised the bar for bonds this year, aiming for bonds rated AA+ or higher rather than AA or better, a senior investment manager at a Chinese brokerage said.

"Investors may be interested in scooping up certain bonds, but some institutions are facing internal constraints following a recent regulatory tightening, and have reduced holdings," added an investment manager at a foreign-backed asset management firm. "Some of them are still dumping private enterprise bonds and lower-rating bonds issued by state-owned enterprises."