Customer concentration, institutions, and corporate bond contracts

• Published date: 01 January 2020
• Author: Chenyan Liu,Hong Xie,Zuoping Xiao
• DOI: http://doi.org/10.1002/ijfe.1731
• Date: 01 January 2020

RESEARCH ARTICLE

Customer concentration, institutions, and corporate bond

contracts

Chenyan Liu

1

| Zuoping Xiao

2

| Hong Xie

3

1

School of Economics and Management,

Southwest Jiaotong University, Chengdu,

China

2

School of Accountancy, Hangzhou

Dianzi University, Hangzhou, China

3

Gatton College of Business and

Economics, University of Kentucky,

Lexington, KY 40506

Correspondence

Zuoping Xiao, School of Accountancy,

Hangzhou Dianzi University,Hangzhou,

Zhejiang Province, China.

Email: xzp4061@sina.com

Funding information

National Natural Science Foundation of

China, Grant/Award Numbers: 71472157

and 71772154

Abstract

We examine the effect of customer concentration, the quality of institutions,

and their interaction on corporate bond contract terms in China. We find that

higher customer concentration is associated with higher bond spreads, shorter

bond maturity, and more bond covenants. In contrast, better institutions are

associated with lower bond spreads, longer bond maturity, and fewer bond cov-

enants. Moreover, we find that the adverse or unfavourable association

between customer concentration and bond contract terms is weakened for

firms operating within better institutions or for firms whose ultimate owners

are the Central Government of China. Furthermore, the adverse association

between customer concentration and bond contract terms is more pronounced

when a supplier's major customers have lower switching costs or when the sup-

plier has made more relationship‐specific investments. Finally, our main

results are robust to controls for endogeneity concerns and other sensitivity

checks. Overall, our findings suggest that bondholders view customer concen-

tration as a risk factor but better institutions as a protection.

KEYWORDS

contract terms, corporate bonds, customer concentration, emerging markets, empirical evidence,

institution

JEL CLASSIFICATION

G10; G12; G20; G32

1|INTRODUCTION

Debt financing is one of the most important sources of

capital all over the world, especially in emerging coun-

tries with undeveloped equity market. Allen, Qian, and

Qian (2005) find that, compared with LLSV countries

(countries in La Porta, Lopez‐de‐Silanes, Shleifer &

Vishny, 1997), Chinese listed firms rely less on equity

markets but more on debt markets. However, “China's

financial system is dominated by a large but underdevel-

oped banking system that is mainly controlled by the four

largest state‐owned banks”(Allen et al., 2005). This leads

to Chinese listed firms' excessive dependence on bank

loans. In recent years, China tries to develop the public

debt market. For example, in December 2008, the Gen-

eral Office of the State Council issued the Guiding Opin-

ions on Accelerating the Development of Economy, in

which it was proposed to expand the total issuance vol-

ume of bonds and develop active debt instruments. In

May 2014, the General Office of the State Council issued

Directive Opinions on Further Facilitating the Sound

Development of Capital Market. These directive opinions

propose to regulate development of bond market, includ-

ing strengthening credit rating, reinforcing regulation,

Received: 6 March 2018 Revised: 11 October 2018 Accepted: 21 March 2019

DOI: 10.1002/ijfe.1731

wileyonlinelibrary.com/journal/ijfe

IntJ Fin Econ.2020;25:90–119.

© 2019 John Wiley & Sons, Ltd.

90

and deepening interconnection in bond market. Over the

last 10 years, the Chinese corporate bond market has

grown from nonexistence before 2007 to 2.3 trillion

RMB in total amount by the end of 2016. Yet, this nascent

but fast‐growing Chinese corporate bond market has not

received enough academic attention.

Prior studies find that many factors affect the price term

(i.e., bond spreads) and non‐price terms (i.e., amount,

maturity, collateral, and covenants) of corporate bond con-

tracts. First, bond contract terms are affected by issuers'

financial characteristics (e.g., Badoer & James, 2016;

Billett, King, & Mauer, 2007; Bradley & Roberts, 2015;

Cook, Fu, & Tang, 2014). Second, issuers' corporate gover-

nance affects bond contract terms (e.g., Boubakri &

Ghouma, 2010; Chava, Kumar, & Warga, 2010; Ghouma,

2017; Liu & Jiraporn, 2010; Tanaka, 2016). Third, macro-

economic environments also affect bond contract terms

(e.g., Awartani, Belkhir, Boubaker, & Maghyereh, 2016;

Cook et al., 2014; Qi, Roth, & Wald, 2011; Qi & Wald, 2008).

Recent studies explore how a firm's customer base

affects the cost of equity capital and bank loan terms.

Depending on major customers, a customer who accounts

for 10% or more of a supplier's sales in a year can be risky

for the supplier

1

because the supplier faces the risk of los-

ing substantial future sales if a major customer becomes

financially distressed, switches to another supplier, or

declares bankruptcy (e.g., Dhaliwal, Judd, Serfling, &

Shaikh, 2016; Hertzel, Li, Officer, & Rodgers, 2008; Mihov

& Naranjo, 2017).

2

Consistent with the above reasoning,

Dhaliwal et al. (2016) find that a supplier with a concen-

trated customer base, that is, the existence of at least one

major customer who accounts for 10% or more of the sup-

plier's total sales, faces high cash flow risk. Consequently,

suppliers with major customers are associated with higher

cost of equity capital, higher bank loan spreads, and higher

corporate bond spreads. Dhaliwal et al. (2016), however,

do not examine non‐price terms for bank loans or corpo-

rate bonds. Campello and Gao (2017) examine how major

customer concentration affects bank loan contract terms

and find suppliers with major customers are associated

with higher bank loan spreads, shorter loan maturity,

and more loan covenants. However, they do not examine

how major customer concentration affects corporate bond

contract terms. Thus, how major customers affect corpo-

rate bond contract terms (except spreads) is unexplored

in the literature. It is worth noting that lenders across pri-

vate debts and public debts differ with respect to their flex-

ibility in resetting contract terms and the cost of

renegotiating the contract (Bharath, Sunder, & Sunder,

2008). In addition, unlike a small number of holders of pri-

vate debts (i.e., banks), public debts are held by a large

number of dispersed public bondholders, whose monitor-

ing of the debt is costly and renegotiating the contract is

also costly. Due to the high monitoring and renegotiation

costs of public debts, public bondholders are likely to

incorporate risk factors such as customer concentration

into price and non‐price terms differently than private

debtholders such as banks. This suggests that we cannot

simply extrapolate what Campello and Gao (2017) find

for private debts to public debts and it is important to

examine public debt separately from private debt.

In China, regulators understand the risk inherent in a

concentrated customer base. For instance, Standard No. 2

for the Contents and Formats of Information Disclosure

by Companies Offering Securities to the Public requires

firms to report the percentage of total sales to five largest

customers and encourages (but does not require) firms to

disclose the name of and sales to each of these five largest

customers. Standard No. 23 for the Contents and Formats

of Information Disclosure by Companies Offering Securi-

ties to the Public requires the firms issuing bonds to dis-

close default events associated with their major

customers within the past 3 years. China Securities Regu-

latory Commission announcement No. 38 requires the

firms to disclose information of operating performance

and debt paying ability if these firms terminate contracts

with their major customers. However, whether and how

customer concentration affects public debt terms (except

spreads) is relatively unexplored for the U.S. bonds as

explained above. It is not explored for Chinese corporate

bonds. Because the corporate bond market in China is

nascent, investors may not be as sophisticated as those

in a mature and well‐functioning bond market like in

the United States. So, we cannot simply extrapolate find-

ings in the U.S. corporate bond market, if any, to Chinese

corporate bond market. To sum, whether and how cus-

tomer concentration affects corporate bond contract

terms is relatively unexplored in the United States and

is unexplored in China. We fill this gap by examining

the effect of customer concentration on corporate bond

contract terms in China.

Prior studies find that the quality of institutions, for

example, rule of law, regulatory effectiveness, financial

development, and creditor rights, affects loan contract

1

We use a supplier, a firm, and a supplier firm interchangeable in this

study.

2

There are at least two other reasons for why depending on major cus-

tomers is risky for a supplier. First, the large customers often use their

bargaining power to obtain favourable terms, resulting in lower profit-

ability and higher liquidity risk for their suppliers (e.g., Bhattacharyya

& Nain, 2011; Fabbri & Klapper, 2016; Fee & Thomas, 2004; Kelly &

Gosman, 2000). Second, suppliers with major customers often need to

hold relationship‐specific investments as a commitment for their cus-

tomers, and these investments become valueless if a supplier loses the

major customer (e.g., Itzkowitz, 2013; Raman & Shahrur, 2008; Titman,

1984; Wang, 2012).

LIU ET AL.91