What drives credit spreads of PRC corporate bonds?

ADB
Donghyun Park, Shu Tian

Financial district in Hohhot, PRC.

Generally, higher bond yields indicate higher financing costs, which in turn influence productive investments and economic activity. Given the rapid growth of the People’s Republic of China (PRC) bond market, and its importance for economic growth, it is worthwhile to understand the pricing dynamics of the market.

Development of PRC corporate bond market



Data sources: WIND Info. Corporate bond data updated on 30 June 2016.

Moreover, as the world's third largest bond market—with $6.5 trillion in outstanding paper at the end of March, including $2.2 trillion in corporate bonds—the PRC bond market is gradually lifting restrictions on foreign investments. Deepening market liberalization offers more opportunities to worldwide investors in terms of both higher returns and portfolio diversification. This research aims to provide up-to-date evidence on the pricing process of PRC corporate bonds, fostering global risk sharing.

According to the literature on the determinants of bond yields globally, credit risk premium and maturity risk premium are the two main components of the mark-up in bond yields. More precisely, credit risk is related to bond issuers' idiosyncratic characteristics. In the structural model framework initiated by Nobel laureate Robert C. Merton in 1974, corporate bonds can be viewed as contingent claims on the underlying value of the issuing firm. The credit quality of a corporation therefore plays a crucial role in bond pricing. Credit quality is commonly quantified by credit spread, which is the difference between yields on corporate bonds and government bonds of the same maturity. Recent research finds that corporate bond credit spreads are related to bond features, corporate characteristics, and the broader economic and market climate.

Using monthly data from May 2008 to June 2016 on exchange-traded corporate bonds in the PRC, we investigated potential factors that influence corporate bond credit spreads. Our sample was restricted to fixed-rate bonds issued by publicly listed firms. In line with the literature, we considered a comprehensive set of proxies to capture risks from three sources: corporate bonds per se, corporate characteristics, and macroeconomic and market conditions.

Bond features carry risk profiles that influence investor preferences and bond demands. Specifically, we focused on the PRC bond credit rating, the remaining time to maturity, and the coupon rate. A higher credit rating and a shorter remaining life effectively reduce associated risk and make a bond more appealing to risk-averse investors, thus narrowing bond credit spreads.

To account for corporate idiosyncratic risk, we considered profitability, leverage, and volatility. Intuitively, greater profitability and lower leverage decrease the probability of default, thus driving down credit spreads. Heightened idiosyncratic volatility may increase bond risk premium because higher volatility may damage the stakes of bondholders but benefit shareholders. Empirically, we utilized earnings before interest and tax (EBIT) to sales ratio and return on assets (ROA) to measure profitability, while the assets to equity ratio was used to measure leverage. We computed the standard deviation of issuers' daily excess stock returns over the preceding 180 trading days to gauge volatility.

For the macroeconomic environment, we include GDP and consumer price index growth (% year-on-year change) to capture economic conditions, and M2 money supply growth (% year-on-year change) to proxy for monetary conditions. The 1-month Treasury yield and the difference between the 10-year and 2-year Treasury yields account for the shape of the term structure in the bond market.

We also controlled for fixed effects to capture time series trends and factors at the issue and sector levels. The second column of Table 1 shows the estimated direction of the effect of these various drivers on the PRC’s corporate bond credit spreads while the last column indicates the statistical significance.

Drivers of credit spreads of PRC corporate bonds


Note: Data from WIND Infor, CSMAR and iFinD. Significance (5% level) is based on robust standard errors.

Our assessment shows that bond features, corporate characteristics, and macroeconomic conditions all have a significant impact on the PRC corporate bond credit spreads. At the micro level, variables that indicate greater risks, such as a lower credit rating, reduced profitability, higher leverage, and increased volatility, typically widen bond credit spreads. At the macro level, greater GDP and M2 growth rates lower corporate bond yields given they measure positive economic prospects and decreased liquidity premium.

We also calculated the percentage of credit spread variance accounted for by each type of variable. The vast majority of the variance in PRC corporate bond credit spreads is explained by micro level factors. Fixed effects that capture sector, issue, and time serial variations account for more than one fourth of variation in credit spreads. Macro factors are quite a bit less important, albeit still significant.

In line with the existing literature, our empirical evidence indicates that PRC corporate bond credit spreads are significantly related to both micro and macro risk factors. Factors that raise default risk widen credit spreads. Meanwhile, positive economic prospects and sufficient liquidity narrow credit spreads. At a broader level, our analysis confirms the importance of a healthy economic environment in containing corporate financing costs.

Shu Tian, Ph.D., is Associate Professor of Finance at Fudan University, PRC.