Liquidity risk and corporate bond yield spread: Evidence from China

• Published date: 01 December 2021
• Author: Yinghui Chen,Lunan Jiang
• Date: 01 December 2021
• DOI: http://doi.org/10.1111/irfi.12322

ORIGINAL ARTICLE

Liquidity risk and corporate bond yield spread:

Evidence from China

Yinghui Chen

1

| Lunan Jiang

2

1

School of Accounting, Zhongnan University

of Economics and Law, Wuhan, China

2

Center for Financial Development and

Stability, School of Economics, Henan

University, Kaifeng, China

Correspondence

Lunan Jiang, Dongliuzhai Building, Henan

University Minglun Campus, 85 Minglun

Street, Shunhe, Kaifeng, 475001, China.

Email: lunan.jiang@vip.henu.edu.cn

Funding information

National Natural Science Foundation of China,

Grant/Award Numbers: 71772179, 71903049

Abstract

This paper investigates the contribution of liquidity risk to

Chinese corporate bond spreads. We calculate corporate

bond spreads based on the full treasury yield curve and

establish a set of liquidity measures of the Chinese corpo-

rate bonds. Our empirical study shows that liquidity pre-

mium accounts for a relatively smaller portion of corporate

bond spread in China, although the market liquidity is low

and corporate bond issuers are strictly pre-screened. These

findings are interesting, as the developed markets have bet-

ter liquidity and less pre-issuance restriction, and liquidity

premium still explains a relatively larger portion of corporate

bond spread. Besides, we also explore the determinants of

Chinese corporate bond liquidity and default premiums.

KEYWORDS

Chinese bond markets, default risk, liquidity risk, yield spread

JEL CLASSIFICATION

C23; G12

1|INTRODUCTION

Over the last four decades, the Chinese bond market has swiftly grown from scratch to roughly $13 trillion in total

outstanding amount. At the same time, foreign institutional investors have shown a lively interest in the Chinese

bond market, because hundreds of onshore Chinese bonds have been added to the Bloomberg Barclays Global

Aggregate Index since April 1, 2019. Hundreds of billions of capital will flow into the third-largest fixed income mar-

ket in the world. However, this nascent but soaring bond market, particularly the corporate bond market, has not

drawn equally increasing attention from the global finance scholars. Our research studies the Chinese corporate

Received: 28 October 2019 Revised: 1 May 2020 Accepted: 10 June 2020

DOI: 10.1111/irfi.12322

© 2020 International Review of Finance Ltd. 2020

International Review of Finance. 2021;21:1117–1151. wileyonlinelibrary.com/journal/irfi 1117

bonds, namely the bonds issued by Chinese public companies and traded in Shanghai and Shenzhen Exchanges, and

adds to the limited literature by investigating the contribution of liquidity and default risk to corporate bond spread

and their determinants.

Our study is essential, considering the tremendous differences between the Chinese corporate bond market and

its counterpart in developed economies. In China, corporate bonds are generally issued by financially secure firms

according to the corporate bond issuance rules published by the China Securities Regulatory Commission (hereafter

CSRC) in 2007, whereas there is no comparable restriction in developed markets. Notably, the CSRC stipulates that

only corporate bonds rated above investment grade can be publicly issued. On top of this, like other emerging mar-

kets, the Chinese capital market is still in its very early stage and underdeveloped in many aspects.

1

For instance, the Chinese bond markets are more illiquid. The mean and the median of Price Dispersion

(a measure of transaction costs that is based on the dispersion of traded prices around the market “consensus valua-

tion”) are 1.53 and 0.50, respectively. This implies that transaction costs in Chinese bond market are very high. These

are around twice as big as the corresponding number for U.S. corporate bond market, around 0.50 and 0.29, respec-

tively, reported by Jankowitsch, Nashikkar, and Subrahmanyam (2011). The median Bond zero trade (the percentage

of days during a year where a bond is not traded) is 88%, which means that in 88% of the time during a year 50% of

the corporate bonds do not trade. In contrast, this index of the U.S. corporate bond market is around 60% (see

Dick-Nielsen, Feldhütter, & Lando, 2012). Given the larger magnitude of illiquidity of the Chinese corporate bond

market, the very first question our study attempts to explore is whether bond liquidity is priced in after controlling

for credit risk. We consider various proxies to measure bond liquidity and then generate a compound liquidity index

by a principal component analysis approach. Our empirical work finds that liquidity risk is well priced and that this

conclusion is both statistically and quantitatively significant. Specifically, we find that Chinese corporate bond

spreads increase by 24–35 bps for one standard deviation in our liquidity index.

If market participants well perceive liquidity risk, the next question is how much the default and liquidity risk,

respectively, account for the corporate yield spread. Disentangling the contribution of liquidity and default risk pre-

miums, however, is nontrivial, because neither liquidity nor its risk is readily and precisely measured. We follow

Dick-Nielsen et al. (2012) and Schwert (2017) to decompose corporate bond spreads into two components, default

and liquidity premiums. We find that default risk explains around 78.25% of the average corporate bond spread over

the period 2009 to 2016. This result interestingly implies that the Chinese bond market participants ignore the no

corporate bond default history, which is brilliant and rational.

2

Surprisingly, we find that the role of liquidity is not as

important as one might infer from the literature on transaction costs in corporate bond markets and that the default

premium absolutely dominates the Chinese corporate bond spreads. This conclusion seems to contradict with the

first impression of fundamental facts of Chinese corporate bond markets mentioned above, especially the high rat-

ings and low liquidity, as, intuitively, the liquidity spread depends on the expected cost of trading and the expected

trading intensity, or the need to sell the bond. The explanation we intend to offer here is that the typical investor in

the Chinese corporate bond market is a buy-and-hold style, like commercial banks, so the trading intensity is low,

whereas the liquidity discount is not so substantial. Moreover, Figure 1 shows that around 58% of total outstanding

amount of bonds were held by commercial banks as of August 2017 in the Chinese bond market, according to China

Central Depository & Clearing Co., Ltd. Therefore, the contribution of liquidity risk to corporate bond spread is not

very large. The increasing weight of liquidity in the total bond pricing also justifies our conjecture, as the reform mea-

sures in the Chinese bond markets, such as introducing more foreign investors and including bonds as collateral for

central bank liquidity injection, adequately diversify the background of participants and give them trading incentives.

Finally, we examine the determinants of corporate bond spread and its liquidity and default related components.

Our results show that total spread, default spread, and liquidity spread are all larger for the bonds with worse credit

ratings. These findings indicate that Chinese bond ratings are informative as Livingston, Poon, and Zhou (2018) dis-

covered. Besides, we also have the following interesting empirical results: Higher ROA leads to lower yield spread

and liquidity spread; the state-ownership of issuers reduces liquidity spread; and the 10-year treasury yield is also an

important determinant of borrowing costs. All the above conclusions are robust under various model specifications.

1118 CHEN AND JIANG

In general, these results are largely consistent with our transaction-based decomposition approach, which success-

fully separates default and liquidity components of the yield spread.

Our work provides important policy implications: If Chinese policymakers intended to reduce the borrowing

costs in bond markets, reducing transaction costs or improve liquidity would not be a sufficient remedy, as the

default premium dominates the bond pricing. Instead, the policies that can significantly lower the default risk pre-

mium could be attractive, for instance, improving the legal framework to deal with corporate bankruptcy and default.

Besides, from the macro-prudential perspective, default risk is more crucial than liquidity risk in containing the

potential bond market crisis. Finally, our study also suggests that the effort of the Chinese government to reform

bond markets during past years does not go in vain, as more liquidity factor gets considered when corporate bond

get pricing.

This paper also contributes to the existing literature in several ways. First, we add the Chinese case to the

research on the effect of liquidity risk on the corporate bond spread. The liquidity and default risk could influence

corporate bond yield spreads very differently in emerging markets, and at least this is true to the Chinese bond mar-

ket. Our evidence implies that liquidity risk is priced in the Chinese corporate bond market, which supports Elton,

Gruber, Agrawal, and Mann (2001); Dick-Nielsen et al. (2012); Longstaff, Mithal, and Neis (2005); and Huang and

Huang (2012). However, liquidity risk only explains for a small proportion of corporate bond spreads, whereas Elton

et al. (2001) and others report that default risk accounts for only a small percentage of corporate bond spread for

U.S. corporate bonds. Moreover, our study also enriches the study on the determinants of corporate yield spreads.

To our best knowledge, this paper is among the first to explore how much the liquidity and default risk is linked to

corporate bond pricing in Chinese markets by using the transaction-based yield spread decomposition approach.

Finally, our paper also relates to the study on Chinese state-ownership and financing costs, which echoes the theory

of Morellec, Valta, and Zhdanov (2015) that firms with higher bargaining power prefer to raise debt by issuing bonds.

The extant literature has brought forth several vital determinants of borrowing costs in emerging markets such as

global stewards, political connections, corporate social responsibility (Gong, Xu, & Gong, 2018; González-Rozada &

Yeyati, 2008; Schweizer, Walker, & Zhang, 2017) from various aspects. We supplement this stream of literature with

the impact of state-ownership, a fundamental and popular dimension for the Chinese market study.

The remainder of this paper is organized as follows. Section 2 reviews the related literature. Section 3 introduces

the characteristics of Chinese bond markets. Section 4 describes the data sources and data filtering procedures. Sec-

tion 5 outlines the empirical design and introduces the liquidity proxies. Section 6 presents the main results and dis-

cusses robustness. Section 7 describes the spread decomposition results. Finally, Section 8 concludes.

57.85 %

28.91 %

5.46 %

5.06 %

2.66 %

0.06 %

Commercial banks

Non−Bank financial intermediaries

Special settlement members

Stock exchanges

QFII

Others

FIGURE 1 Investor composition of

the Chinese bond market. This figure

presents the investor composition of the

Chinese bond market, including

commercial banks, non-bank financial

intermediaries, special settlement

members, stock exchanges, qualified

foreign institutional investors (QFII), and

others as of August 2017 from China

Central Depository & Clearing Co., Ltd

CHEN AND JIANG 1119