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International Pricing of Emerging Market Corporate Debt: Does the Corporate Matter?

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International Pricing of Emerging Market Corporate Debt: Does the Corporate Matter? WP/10/26 International Pricing of Emerging Market Corporate Debt: Does the Corporate Matter? Sonja Keller and Ashoka Mody © 2009 International Monetary Fund WP/10/26 IMF Working Paper European Department International Pricing of Emerging Market Corporate Debt: Does the Corporate Matter? Prepared by Sonja Keller and Ashoka Mody1 January 2010 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. We examine risk spreads charged on corporate bonds placed by emerging market borrowers on international exchanges. While global developments have an important effect on spreads, changes in firm-level default risk also matter significantly in a way consistent with theory and experience in mature markets. In contrast, except during periods of financial crisis, country factors play a limited role. These findings go against the supposition that limited information on emerging market firms or significant agency problems prevent firm-level credit discrimination by international investors. The firm-level information capitalization into spreads possibly reflects protection afforded by the exchange listing on international markets. JEL Classification Numbers: F3; G1; G3 Keywords: Corporate bonds, bond spreads, Fama-French factors Author’s E-Mail Address: [email protected], [email protected] 1 The authors are respectively with University of Stellenbosch, Cape Town, South Africa, and the International Monetary Fund. Keller was an intern at the Fund when the research commenced. For comments on earlier drafts, the authors are grateful to Steve Bond, Stan du Plessis, Barry Eichengreen, Simon Johnson, Kohei Kawamura, and John Muellbauer. 2 Contents Page I. Introduction ............................................................................................................................3 II. Theoretical and Empirical Framework ..................................................................................6 A. Structural Models of Credit Spreads .........................................................................6 B. Corporate Bond Spread Literature ............................................................................7 C. Stylized Facts ............................................................................................................8 III. Data and Methodology .........................................................................................................9 A. Data ...........................................................................................................................9 B. Pooled OLS, Fixed-Effects and GMM Methodology .............................................10 IV. Determinants of Spreads ....................................................................................................11 A. Background .............................................................................................................11 B. Bankruptcy Risk ......................................................................................................15 C. Recovery Rate and Economic Fundamentals ..........................................................16 D. Global Factors and Systematic Risk .......................................................................17 V. Conditioning on Country Features ......................................................................................17 A. Measures of Investor Protection .............................................................................17 B. Synchronicity ..........................................................................................................18 C. Country Risk during Financial Crises .....................................................................18 VI. Structural Breaks ...............................................................................................................19 VII. Robustness Testing and Extensions .................................................................................21 A. Cross-sectional Dependence and Principal Component Analysis ..........................21 B. Systematic Component of Firm-level Factors .........................................................22 C. Omitting Time Dummies for Outliers .....................................................................22 VIII. Conclusion ......................................................................................................................22 References ................................................................................................................................24 Tables 1. Descriptive Statistics of Data Sample ..................................................................................31 2. Within-Group, IV and GMM Estimates ..............................................................................32 3. Default Risk and Altman’s Z-Score .....................................................................................33 4. Expected Recovery Rate, Fama-French Factors and Transfer Risk ....................................34 5. Break Dates Using Classical Testing and MMSC in a Panel Set-Up ..................................35 6. Model Estimation When Allowing for Structural Break .....................................................36 7. Alternative Treatment of Time Effects ................................................................................37 Figures 1. Spread on Emerging Market Bonds .....................................................................................28 2. Global Equity Market Volatility and Spreads ......................................................................28 3. U.S. Treasury Yield and Emerging Market Spreads............................................................29 4. Firm-level Volatility, Leverage and Equity Returns ............................................................30 5. Principal Component Analysis on Log-spreads and Regression Residuals .........................30 3 I. INTRODUCTION The pricing of emerging market assets is thought to principally reflect changes in global sentiments and country risk. In turn, country risk is a reflection of a lack of sufficient information, agency problems (inability of a foreign lender to monitor a distant borrower), and sovereign risk. For these reasons, it is generally believed that foreign investors and lenders will tar all operations within a country with the same brush. Exceptions are known to exist—firms with strong “hard” currency earnings escape the country embrace. Yet the evidence on the importance of country-level factors in emerging markets asset pricing is considerable. Brooks and Del Negro (2002) decompose stock returns into industry and country components, concluding that country returns are salient, particularly for emerging markets. Morck, Yeung and Yu (2000) find a high degree of synchronicity of stock prices in emerging economies, from which they infer that individual variations in firm-specific return and risks are not actively priced. For bond markets, Eichengreen and Mody (2000) find that country growth, debt, and volatility explain differences in spreads across countries, though they do not sufficiently differentiate corporate issuer characteristics. Thus, despite significant reductions in barriers to cross-border investment and increased financial globalization, country factors remain important in asset pricing. Stulz (2005) suggests that the risk of expropriation by the state (the traditional country risk) and by corporate insiders could account for the continued importance of country effects. A similar view is supported by Morck, Yeung and Yu (2000), who argue that weak protection of property rights against corporate insiders raises market-wide noise trading and discourages informed risk arbitrage and the capitalization of firm-specific information into stock prices. In emerging markets, pyramidal structures allow corporate insiders control rights in excess of cash flow rights, aggravating the agency problem (Durnev and Kim, 2005). Johnson, Boone, Breach and Friedman (2000) argue, for example, that the protection of minority shareholders and measures of corporate governance are important in understanding the severity of the stock market decline during the Asian crisis. Can emerging market firms bypass their domestic markets and institutions and receive credit for their distinguishing characteristics? This question has received some attention in the case of stocks. Analyses of American Depository Receipts (ADRs) find that cross-listing on the U.S. exchange decreases the local market beta, suggesting a reduced role for country factors in firm equity returns when securities are placed on the international market and are bound by the more stringent disclosure and enforcement framework of the U.S. Securities and Exchange Commission (SEC) (Foerster and Karolyi, 1999). Little, however, is known regarding the role of firm-level characteristics for a comprehensive sample of emerging market corporate bonds issued on the international market. This paper is a first effort to fill that gap. Peter and Grandes (2005) examine spreads on local currency bonds, highlighting the central role of country risk relative to firm-level factors, yet their analysis is limited to bonds issued in South Africa.
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