Credit rating agencies (CRAs) play an important and powerful role in well-developed corporate bond markets. The credit ratings assigned to issuers and issues are significant determinants of the price that issuers will pay to buy bonds.
Credit ratings are measures of default risk and thereby provide pricing benchmarks for investors. Other benchmarks used to price bonds include the size of the issue, the term to maturity, secondary market liquidity, accrued interest etc.…
The critical role played by CRAs has ensured that they are regulated at both a national and international level. CRAs have been regulated by the Securities and Exchange Commission in the United States since 1975. Internationally, regulation is co-ordinated by IOSCO – the International Organization of Securities Commissions - with substantial moves being made toward global harmonisation since the GFC.
But national regulation and/or a lack of market development can work against CRAs and the use of credit ratings. The reputation of CRAs and therefore the influence of credit ratings may take many years to develop. Some of the larger global CRAs have a history that dates back to 100 to 150 years.
Recognising the role of CRAs in well-developed bond markets, academics Raghav Dhawan and Fan Yu, set out to test the influence of CRAs in the less developed Chinese bond market.
In their 2015 paper “Are Credit Ratings Relevant in China’s Corporate Bond Market?”, published in The Chinese Economy, they test the influence of Chinese CRAs that haven’t had the same luxury of time to develop their reputations and influence, as their American counterparts.
Bond markets really only emerged in China in 2005, when the People’s Bank of China (PBOC) removed a requirement for all bond issues to be guaranteed by a state-owned bank. Removal of the state guarantee from bond issues forced investors to consider default risk for the first time, and provided Chinese CRAs with an opportunity to prove their value.
Dhawan and Yu say that prior to the removal of the state guarantee, China’s CRAs had little to do but rubber stamp the bond issues with their highest ratings. Credit ratings were purely “ornamental”.
However, since the transformation of the Chinese bond market, the influence of Chinese CRAs has been uncertain. There have been reports of corruption and a willingness to assign inappropriate credit ratings in order to win business.
While the operation of CRA’s is regulated by the PBOC, which has licenced the operation of only four CRAs, it is hard not to think that where there is smoke, there is fire. The ratings that have been assigned to bond issuers are limited to just three: ‘AAA’, ‘AA ’ and ‘AA’.
But Dhawan and Yu note that it is empirically difficult to test the relationship of the rating to default risk. Initial bond issues were from firms of the highest credit quality and (up to the time of their research) defaults were non-existent.
Using credit ratings assigned by China Chengxin International Credit Rating Co. Ltd. (49% owned by Moody’s Investors Service) Dhawan and Yu test the influence of credit ratings as pricing benchmarks. They find that despite the limited history of credit ratings in China, investors are using credit ratings to tier the pricing of corporate bonds accordingly.
Credit ratings are found to be significant determinants of yield spreads between ‘AA ’ and ‘AA’ rated bonds, relative to ‘AAA’ rated bonds. After controlling for the other determinants of bond yields, average yields on ‘AA ’ rated bonds are found to be 21bps wider than yields on ‘AAA’ rated bonds, and average yields on ‘AA’ rated bonds are found to be 88bps wider.
Philip Bayley
Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.
