CRA Reputation and Bond Yield: Evidence from the Chinese Bond Market

• Published date: 01 April 2019
• DOI: http://doi.org/10.1111/ajfs.12251
• Date: 01 April 2019

CRA Reputation and Bond Yield: Evidence

from the Chinese Bond Market*

Xiaolu Hu

School of Economics, Finance & Marketing, RMIT University, Australia

Haozhi Huang

Department of Applied Finance, Macquarie University, Australia

Jing Shi

Department of Applied Finance, Macquarie University, Australia and

School of Finance, Shandong University of Finance and Economics, China

Hua Wang**

School of Accounting, Zhongnan University of Economics and Law, China

Received 31 July 2018; Accepted 8 February 2019

Abstract

The paper examines the reputation effect of credit rating agencies (CRAs) in China. We find

a negative association between CRAs’ reputation and public bonds’ offering yield spreads

after controlling for endogeneity. Analyses of the correlation between CRA reputation and

bond return volatility in the aftermarket and cross-sectional variations of reputation effects

alongside a host of information environment proxies for issuers, we identify the information

channel through which CRA reputation plays its role. This is further supported when we uti-

lize an exogenous event, the introduction of an independent CRA (the China Bond Rating

Co. Ltd), to explore the potential changes of the reputation effect.

Keywords Credit rating agencies; Information environment; Reputation; Yield spreads

JEL Classification: G12, G24, G28

*The authors greatly appreciate comments from participants at the 2017 China Accounting

and Finance Conference held in Beijing. Our gratitude also goes to colleagues from RMIT

and Macquarie University. We also acknowledge China Bond Rating Co. Ltd for allowing us

to use its database.

**Corresponding author: School of Accounting, Zhongnan University of Economics and

Law, 182 Nanhu Ave, East Lake Economic Development Zone, Wuhan 430073, China. Tel:

+86-137-0718-7358, Fax: +86-278-838-6515, email: huawang@zuel.edu.cn.

Asia-Pacific Journal of Financial Studies (2019) 48, 185–209 doi:10.1111/ajfs.12251

©2019 Korean Securities Association 185

1. Introduction

Financial intermediaries are critical to capital markets due to the roles they play,

such as information producer and market gatekeeper. Traditionally, investigation of

the reputation effect has focused on equity markets, such as the initial public offer-

ing (IPO) market (e.g., Nanda and Yun, 1997; Carter et al., 1998), and on financia l

intermediaries, such as auditors, lead arrangers in syndicated loans, and stock ana-

lysts (e.g., Jackson, 2005; Gopalan et al., 2011). Although the size of the bond mar-

ket is generally larger than the size of the equity market, less attention has been

paid to the debt market SIFMA (2017). In this paper, we provide insight on the

issue by investigating the reputation effect of credit rating agencies (CRAs) on the

costs of public debt using data from China’s bond market.

The reputation of CRAs is of particular interest due to the quasi-government

nature they adopt through regulations, which affects more than just investors.

Specifically, regulators in many countries have linked credit ratings to bond inves t-

ment rules and capital requirements in terms of risk calibrations for bond-holding

institutions. For instance, under SEC Rule 2a-7 in the US, money market mutual

funds are required to limit investments in bonds rated less than A+and commercial

papers rated less than Al.

Despite the critical role played by CRAs, investors’ confidence in them has

dropped significantly since the 2007–2009 sub-prime crisis. As the US Financial Cri-

sis Inquiry Report (2011) concludes, CRAs were “the essential cogs in the wheels of

the financial destruction,” and the “big three”—S&P, Moody’s, and Fitch—were the

“key enablers of the financial meltdown.” Researchers have illustrated that the eco-

nomic incentives linked to the business models adopted by most CRAs (i.e., the

issuer-pay model) are to blame (Cornaggia and Cornaggia, 2013; Kashyap and

Kovrijnykh, 2016), and market forces (i.e., competition) did not work well under

the economic conditions during that period (Faure-Grimaud et al., 2009; Becker

and Milbourn, 2011; Baghai et al., 2014). Nevertheless, the aforementioned conclu-

sions are mainly based on studies of developed markets. Whether the reputation of

CRAs matters in emerging markets that feature distinctive institutions remains

unexplored. In this paper, we explore the reputation effect of CRAs in a nascent

but rapid growing bond market in China CNBC (2017).

The Chinese bond market provides a unique setting to study the role of CRAs’

reputations. First, the effect of their reputation is more significant when there is a

lack of effective legal enforcement. As suggested by MacLeod (2007), informal

enforcement, such as the involvement of reputation, becomes more efficient when

the litigation costs are high. China has long been viewed as a country with a poor

legal environment (La Porta et al., 2004; Allen et al., 2005). Ineffective legislative

regimes result in either unfair trial results or prolonged procedures, driving up liti-

gation costs. Second, a lower market share would make reputational assets more

valuable to firms. This is because firms need to differentiate themselves from others

by building their reputation when there is a lot of competition in the market. As

X. Hu et al.

186 ©2019 Korean Securities Association