Counter‐Credit‐Risk Yield Spreads: A Puzzle in China's Corporate Bond Market

AuthorXiaoxia Ye,Jian Luo,May Hu
Date01 June 2016
Published date01 June 2016
Counter-Credit-Risk Yield Spreads: A
Puzzle in Chinas Corporate Bond
Wang Yanan Institute for Studies in Economics, Xiamen University, Xiamen, China,
Stockholm Business School, Stockholm University, Stockholm, Sweden and
Deakin Graduate School of Business, Deakin University, Melbourne, Australia
In this paper, using Chinas risk-free and corporate zero yields together with
aggregate credit risk measures and various control variables from 2006 to
2013, we document a puzzle of counter-credit-risk corporate yield spreads.
We interpret this puzzle as a symptom of the immaturity of Chinas credit
bond market, which reveals a distorted pricing mechanism latent in the fun-
damental of this market. We also nd interesting results about relationships
between corporate yield spreads and interest rates and risk premia and the
stock index, and these results are somewhat attributed to this puzzle.
JEL Codes: G12; E43
In China, banks have long been the primary source of capital. Total outstanding
bank loans are 10 times larger than that of credit bonds (Ma, 2006; Suzuki et al.,
This paper was previously circulated under the title A Puzzle of Counter-Credit-Risk Corporate Yield
Spreads in Chinas Corporate Bond Marketby the rst two authors. We would like to thank Hong
Yan (the editor), Hui Chen, Jing-Zhi Huang (discussant at the 2014 CICF), Van Vu (discussant at the
5th FMCGC), and Fan Yu for their great, helpful discussions; Reena Aggarwal, Banita Bissoondoyal-
Bheenick, Robert Durand, Robert Faf , Michael Graham, Bj örn Hagströmer, Mia Hinneri ch, Ai Jun
Hou, Jia Hua, Michael Keefe, Steven Li, Hai Lin, IñakiRodriguez Longarela, Lars Nordén, Leigh Roberts,
Goran Zarovand seminar participantsat the Stockholm BusinessSchool, the 5th FinancialMarkets and
CorporateGovernance Conference, the2014 China International Conference in Finance,and the VUW
School of Economicsand Finance for their helpfulcomments; Tieliang Guoand Martin Lueken for read-
ing earlier draftsof this paper and their insightful comments; Tingguo Zheng for providing us the (up-
dated) GDP Growth data used in Zheng and Wang (2010); and the Risk Management Institute at the
National University of Singapore for making their aggregate credit risk measures freely available online.
All remaining errors are our o wn.
© 2016 International Review of Finance Ltd. 2016
International Review of Finance, 16:2, 2016: pp. 203241
DOI: 10.1111/ir.12079
The Chinese government itself has realized that this highly skewed nan-
cial system accumulates systemic risks. Regulatory reform, with ofcials clearing
away some of the obstacles that have stood in the way of the development of
the bond market (Mu, 2006; Zhou, 2003; Zhou, 2006), has been constantly
advancing the development of Chinas credit bond market. After the Peoples
Bank of China (PBC) launched commercial papers (CPs) in 2005, Chinas credit
bond market entered into its fast growth period. By 2012, the annual issuance
of the whole market is RMB 2 trillion, which is about seven times the amount in
2005. With this speed of growth, the credit bond market is becoming more and
more important in China. Given Chinas increasingly important and inuential
role in the global economy,this market will soon become one of the indispensable
members in the international investment community. Therefore, it deserves
timely and careful studies that target not only Chinese but broader research audi-
ence. Hale (2007) and Chen et al. (2011) describe the current status and the recent
developments of Chinas credit bond market. Huang and Zhu (2009) provide an
overview of the history of Chinas credit bond market, although their focus is
on the whole bond market. To the best of our knowledge, however, there has been
no previous literature that provides quantitative empirical studies on this market.
Using a set of comprehensive zero yield curve data of Chinas government
bonds and credit bonds, along with Chinas aggregate credit risk measures, mac-
roeconomic variables, and an aggregate liquidity measure from 2006 to 2013, we
surprisingly nd a puzzle of counter-credit-risk corporate yield spreads (YS). In
other words, we nd a signicant and negative relationship between the corpo-
rate YS and aggregate credit risk measures. This result is completely counterin-
tuitive given the fact that a corporate bond market is naturally expected to
discover the price of credit risks in a directly proportional way.
Specically, we rst use a three-factor Gaussian term structure model to cap-
ture the dynamic of the term structure of risk-free interest rates. Then, we
develop a ve-factor afne defaultable bond model, in which the rst three fac-
tors coming from the interest rate model represent the risk factors of the interest
rates, and the other two factors (CIR processes) capture the corporate-specic
component (the component in the corporate yield spread that is uncorrelated
to the risk-free interest rate factors) implicit in the term structure of corporate
YS. This ve-factor model is tted to the corporate zero yield curve data of bonds
with different ratings. Results of the model allow us to study (i) the relationship
between corporate YS and risk-free interest rates; (iii) the dynamics of the
corporate-specic component; and (iii) the dynamics of corporate-specic risk
premia. We nd that the corporate YS are negatively related to the level of the
risk-free interest rates but positively related to the slope and curvature of the
interest rates. The positive relationships with the slope and curvature, which
1Credit bondis a term unique to the Chinese market. It is similar to corporate bond in the gen-
eral sense. However, corporate bondis used in China to represent a sub-market of the whole
credit bondmarket. The relationship between different terms will become clear as we move
on to the section describing Chinas credit bond market.
International Review of Finance
© 2016 International Review of Finance Ltd. 2016204
contradict theoretical predictions (Collin-Dufresne et al., 2001; Longstaff &
Schwartz, 1995), might be attributed to the counter-credit-risk puzzle.
We then regress the model implied corporate-specic components on the
aggregate credit risk measures. The regression results formally conrm the
counter-credit-risk puzzle: the corporate-specic components are signicantly
and negatively related to the aggregate credit risk measures. The results are robust
to different aggregate credit risk measures and to the inclusion of various control
variables. The control variables include the non-performing bank loan rate, the
stock index, the GDP growth rate, and an aggregate bond market liquidity mea-
sure. Next, we regress the model implied corporate-specic risk premia on the
aggregate credit risk measures and the control variables. We nd that the risk
premia are not consistently and signicantly related to the credit risk, and they
are, however, signicantly and negatively related to the GDP growth. This is con-
sistent with the evidence in Adrian et al. (2010) about the relationship between
the GDP growth and themacro risk premium. For higher (lower) ratings, they have
a signicantly positive (negative) relationship with the stock index (the non-
performing bank loan rate). This might indicate that for the credit bond
investors, the equity and bank loan markets are comparable substitutes in the
sense that when the equity market and/or bank loan market perform better
(worse), the opportunity cost of investing in the credit bond market becomes
higher (lower), therefore the requested risk premium is higher (lower). The results
of the risk premia help us understand the cause and mechanismbehind the puzzle.
We interpret this puzzle as one of the symptoms of the immaturity of Chinas
credit bond market. The liquidity in the secondary market is very low, which pre-
vents the bond prices from revealing the true underlying risks. At the same time,
zero default experience in the past two decades plus the explicit or implicit guar-
antees provided by high prole parent companies or local governments attract
credit risk sensitive capital when the overall credit condition deteriorates. This
distorted pricing mechanism might funnel the credit risks to the credit bond
market instead of diversifying the credit risks. The emergence of the symptom
alerts policy makers to focus more on the secondary market development and
correction of the credit risk pricing mechanism.
The remainder of this paper is organized as follows. Section 2 provides a brief
introduction to Chinas credit bond market. Section 3 describes the data, and pre-
sents results of some preliminary analyses, which already reveal the counter-
credit-risk puzzle. In Section 4, we derive the term structure models that are used
to identify the corporate-specic risk factorsand risk premia from risk-free and cor-
porate zeroyields. Section 5 presents formalempirical analyses. Section6 concludes
the paper. Appendicescontain technical details andsupplemental empirical results.
Chinas creditbond market started in 1983. While before 2005 thedevelopment of
the market was ratherslow, it has beenrapidly developing since 2005 in whichthe
Counter-Credit-Risk Yield Spreads
© 2016 International Review of Finance Ltd. 2016 205

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