The evolving liquidity premium in a retail-driven corporate bond market

ECONOMISTS have long agreed that the rate of interest on a loan depends on the risks the lender incurs. But how lenders estimate these risks has been left largely to conjecture. This paper presents and tests a hypothesis about the determinants of risk premiums on corporate bonds. By risk premium is meant the difference between the market yield on a bond and the corresponding pure rate of interest. My hypothesis is as follows: (1) The average risk premium on a firm's bonds depends first on the risk that the firm will default on its bonds and second on their marketability. (2) The "risk of default" can be estimated by a function of three variables: the coefficient of variation of the firm's net income over the last

Fact or fiction: Implicit government guarantees in China’s corporate bond market

This paper investigates the impact of multidimension liquidity, credit risk, and the interaction between liquidity and credit risk on corporate bond spreads based on a large transaction data set from July, 2006 to June, 2016, including the monthly data of 3716 bonds in China. Our main findings reveal that liquidity premiums are the main parts of corporate bond spreads. The interaction between liquidity and credit risk plays a significant role in determining corporate bond spreads. In addition, the differences between the interbank market and the exchange market have a significant impact on corporate bond spreads in normal period, and the interaction between liquidity and credit risk has an enhanced impact on corporate bond spreads during financial crisis. We also find that the interaction between liquidity and credit risk will increase with the increase of liquidity risk and credit risk and it is a time‐varying dynamic process.

This paper explores how implicit government guarantees affect the yield spreads of Chinese corporate bonds. We argue that quasi-municipal corporate bonds (“Chengtou” bonds), issued by local government financing vehicles (LGFVs), carry an implicit government guarantee. Using a sample of publicly traded corporate bonds between 2010 and 2017, we show that bond investors are significantly less sensitive to bond-specific risks for corporate bonds with an implicit government guarantee: the yield spreads of Chengtou bonds are significantly lower than those of corporate bonds issued by privately-owned enterprises (POEs) in China. We also find that corporate bonds from Northeast China are riskier than those issued by firms elsewhere in the country. Furthermore, we find that policy changes introduced by China’s central government, which were intended to regulate local governments’ debt financing activities, significantly reduced the gap in yield spreads between Chengtou bonds and bonds issued by POEs. Overall, our results suggest that implicit government guarantees play a crucial role in China’s corporate debt market and that China’s recent policy changes reduce the effectiveness of implicit government guarantees, making China’s corporate bond market more market-oriented.

Corporate bond liquidity and yield spreads: A review

This paper employs a new approach to estimating the size of liquidity premia in the credit default swap (CDS) and corporate bond markets. We develop a CDS pricing model with liquidity and default, and a corporate bond pricing model with default, taxes, and liquidity using the reduced-form approach, and jointly estimate parameters of both pricing models from pooled data using the generalized method of moments. By formulating default intensity as a common factor of the spreads of the CDS and reference bonds, we are able to identify the liquidity and other components of spreads more precisely. We find that both CDS and corporate bond spreads contain significant liquidity components. On average, the liquidity premium accounts for 13% of the CDS spread and 23% of the corporate yield spread. The size of the liquidity premium increases as the rating decreases. Estimates of liquidity premia in the CDS and corporate bond markets are highly correlated, and closely linked to bond-specific and aggregate liquidity measures. Results show that liquidity is important for CDS and corporate bond pricing. Ignoring CDS illiquidity results in a significant bias in estimation of corporate yield spread components when using the CDS information to aid in decomposition of spreads.

We investigate pricing implications of regulation-induced fire sales in corporate bonds. Insurance companies, the dominant investors in the corporate bond market, are also subject to regulatory restrictions that can induce commonalities in their investment behavior. In particular, a bond downgrade can trigger a ‘fire sale’ if greater capital requirements and other regulatory constraints prompt its widespread divestment. Using data on insurance companies’ holdings in corporate bonds, we approximate the amount of fire sale risk by the percentage of total par amount of a bond held by insurance companies. Using exogenous variation in the demand for particular bonds, we show that fire sale risk has significant explanatory power for corporate bond yield spreads, after controlling for the general effect of liquidity, credit risk and other traditional bond pricing factors. The effect of fire sale risk on bond yield spreads is more pronounced: when a bond is held by more regulatory-constrained insurance companies, for subsample of bonds with credit ratings closer to the NAIC risk categories with higher capital requirements, and during the recent financial crisis.

A corporate bond market has the potential to play an important role as a supplement to bank-oriented financial systems in emerging markets—functioning in effect as a ‘spare tire’. Yet bond markets typically rely upon formal institutions that are lacking in developing economies. Despite significant institutional weaknesses, China’s corporate bond market has grown to become the third largest in the world. In this article, we use a network perspective to explore the formation, operation, and function of the Chinese corporate bond market. We explain the market’s exponential growth as a result of a network of relationships among state-owned or linked actors that has substituted for formal institutions. But the consequences of this state-centric network may undermine the spare tire function. We begin by unpacking the complexities of the market’s structure and formal regulation, which have been shaped by a surprising degree of regulatory competition. Next, we analyse China’s corporate bond market as a network of relationships that invariably lead back to the state, and explore the consequences of this network on the pricing, rating, and default of corporate bonds. The paper concludes by highlighting several important policy issues raised by our analysis, including the consequences of regulatory competition, the potential role of the bankruptcy system in handling issuer financial distress, and the linkages between the corporate bond market and China’s rapidly expanding shadow banking system. The size, and institutional fragility, of the Chinese corporate bond market illustrate both the accomplishments and limitations of state capitalism.

I employ the corporate bond liquidity premium to understand the important changes in corporate bond market liquidity from 2004 to 2019. I show that while commonly-used transaction cost measures such as the bid-ask spread have been declining, the corporate bond liquidity premium has actually increased since the financial crisis. For speculative bonds, about 30% of their yield spread now compensates for illiquidity compared to 15% before the crisis. I demonstrate that this increasing liquidity premium is due to investors facing longer trading delays as dealers have become less willing to provide immediacy, and develop a structural over-the-counter model to estimate the latent trading delays implied by the size of the liquidity premium. The estimation results suggest that bonds that took less than one day to sell before the financial crisis now take weeks to trade. Finally, I establish a causal relationship between the major post-crisis regulations and the variations in the corporate bond liquidity premium to uncover the potential cause of dealers' unwillingness to provide liquidity. I show that Basel II.5, by introducing the stressed value-at-risk and incremental risk charges for credit products, contributed the most to increasing the liquidity premium out of all regulatory changes examined. The longer trading delays and the impact of regulations are consistent with practitioners' descriptions of the post-crisis market and corroborate the relevance of using the liquidity premium to understand corporate bond market liquidity.

We use a unique data-set to study liquidity effects in the US corporate bond market, covering more than 20,000 bonds. Our analysis explores time-series and cross-sectional aspects of corporate bond yield spreads, with the main focus being on the quantification of the impact of liquidity factors, while controlling for credit risk. Our time period starts in October 2004 when detailed transaction data from the Trade Reporting and Compliance Engine (TRACE) became available. In particular, we examine three different regimes during our sample period, the GM/Ford crisis in 2005 when a segment of the corporate bond market was affected, the sub-prime crisis since mid-2007, which was much more pervasive across the corporate bond market, and the period in between, when market conditions were more normal. We employ a wide range of liquidity measures and find in our panel-regression analysis that liquidity effects account for approximately one-tenth of the explained market-wide corporate yield spread changes. During periods of crisis, the economic impact of the liquidity measures increases significantly. Our data-set allows us to examine in greater detail liquidity effects in various sub-segments of the market: investment grade vs. speculative grade bonds, financial sector firms which have been particularly affected by the crisis vs. industrial firms, and retail vs. institutional trades. In addition, our cross-sectional analysis based on Fama-MacBeth regressions shows that liquidity explains an important part of the variation in yield spreads across bonds, after accounting for credit risk. These results yield important insights regarding the liquidity drivers of corporate bond yield spreads, particularly during periods of crisis.

In this study we highlight the importance of liquidity risk, especially in periods of market stress, and advocate in favour of an explicit consideration of a liquidity premium when using mark-to-model methodologies to value financial assets.For European corporate bonds, we show that the liquidity premium, calculated as the difference between the yield spread of corporate bonds and the spread of credit default swaps, grew significantly during the recent market turmoil not only in absolute terms but also in relative terms. Although liquidity premiums were far from stable during the time frame of analysis – from 1 January 2005 to 31 December 2009 – on average roughly 40% of corporate yield spreads can be interpreted in terms of liquidity premia.We propose direct matching between the CDS and the underlying reference assets when computing liquidity premia. This differs from what seems to be the industry standard, which is simply to use indices when trying to infer market implied liquidity premia. Although computationally more demanding, the method we use is sounder from a theoretical point of view and produces richer results and analysis. With this method we are able present an analysis of liquidity risk premia per sector of activity.

The cross-section of Chinese corporate bond returns

China’s bond market has been ranked third globally; however, China’s corporate bonds are significantly less liquid than its stocks. Liquidity risk is an important component in China’s corporate bond spreads. In this paper, we propose a stochastic liquidity discount factor model to evaluate the liquidity risk premium and its term structure in China’s corporate bond market. The Monte Carlo simulation technique is used to quantify the impact on the liquidity premium of various liquidity factors: the liquidity level, liquidity volatility, liquidity shock, and the liquidity elasticity. Our findings conclude that the liquidity level is the most significant component of a liquidity premium. The impact on the liquidity premium of other liquidity factors is all conditional on the liquidity level. In addition, the impact of liquidity shocks and volatility is also subject to the market’s equilibrium mechanism. Further, the term of a bond affects the premium both directly and indirectly through its influence on a bond’s liquidity.

Purpose This paper aims to investigate the political cost hypothesis and the effects of political sensitivity-induced governance in the US bond market by using yield spreads from bonds issued by a diverse sample of US government contractors. Design/methodology/approach Fixed effects regression analysis is used to test the relation between the political sensitivity of government contractor firms and their cost of debt. Findings Results illustrated that government contractors with greater political sensitivity are associated with larger yield spreads, indicating that bondholders require a premium when firms endure the costs of increased political oversight and the threat of outside intervention, reducing the certainty of future income. However, despite the overall positive impact of political sensitivity on bond yield spreads on average, the authors found that the additional government oversight is associated with lower spreads when the firm is facing greater repayment risk. Practical implications Despite the benefits of winning a government contract, this paper identifies a direct financial cost of increased political sensitivity because of additional firm oversight and potential intervention. Importantly, it also finds that this governance is valued by bondholders when faced with increased risk. Firms must balance their desire for government receipts with the costs and benefits of dependence on those expenditures. Originality/value This paper contributes to the literature in its exploration of political sensitivity as an important determinant of the cost of debt for corporate government contractors. Specifically, the authors document a significant risk premium in bond pricing because of the joint effects of the visibility and importance of government contracts to the firm.

This article investigates the nexus among the liquidity measures, credit ratings, and the yield spreads of green corporate bonds in China using panel data analysis and the generalized method of moments (GMM). Lower market liquidity, a lower credit rating level, and a shorter issued age are more significant for enlarging the yield spreads of ordinary corporate bonds than those of green corporate bonds. Compared with the AAA credit rating level, the illiquidity ratio, nontrade frequency ratio, zero-trade volume, yield volatility, interest rate margin and issued age have more significant influences on the yield spreads of ordinary corporate bonds than those of green corporate bonds. The liquidity and credit rating have greater differences in affecting the yield spreads of green corporate bonds with different issuance terms.