A corporate bond is more valuable when lenders view it as good enough to back a loan. This potential use as collateral—or pledgeability—typically means that lenders will take less of a discount, or “haircut,” off a bond’s face value in offering financing against it.
While the theory behind this is well established, putting an empirical value on pledgeability has been a challenge. But in a recent study in China’s bond market, researchers find an average yield change of 53 basis points, giving a price to bond pledgeability for the first time.
On December 8, 2014, Chinese regulators unexpectedly changed the rules overnight on a significant slice of corporate bonds. This enabled MIT’s Hui Chen, Tsinghua University’s Zhuo Chen, Chicago Booth’s Zhiguo He, University of International Business and Economics’ Jinyu Liu, and CITIC Securities’ Rengming Xie to see how pledgeability affected bond values while other factors remained unchanged.
In China’s bond market—the third largest, behind the United States and Japan—some corporate bonds trade simultaneously on two markets. The interbank bond market is an over-the-counter market that serves banks and other nonbank financial institutions including mutual funds, security firms, and insurance companies, while the exchange bond market features centralized trading and is used by the above-mentioned nonbank financial institutions and retail investors.
Chinese regulators suddenly ruled that bonds rated below AAA couldn’t be used as collateral on the centralized exchange market, but they allowed the same, lower-rated bonds to retain their pledgeability on the interbank market.
The regulatory change rendered class AA+ and AA bonds on the centralized exchange ineligible for use in repurchase agreements, or repos, a popular form of short-term borrowing. The change did not affect AAA and AA- bonds; the latter were ineligible for repos even before the new rules. These unaffected bonds provided controls for the study.
The researchers find that as the affected bonds’ market prices dropped after the change, yields rose between 24 and 83 basis points, or 0.24 to 0.83 percentage points. Bond yields, which are the promised investment returns earned by investors, move inversely to price. The average yield change was 53 basis points, which translated to an average price change of 3.32 RMB for a bond with a face value of 100 RMB.
A large body of research aims to peg the equilibrium value—the perfect price to match buyers and sellers—of market assets such as stocks and bonds. The findings quantify the value of pledgeability, which is one of many factors related to liquidity with important influence on asset prices.