The determinants of credit spread changes in Japan

Transcription

1 Bank of Japan Working Paper Series The deerminans of credi spread changes in Japan Shinsuke Ohyama * shinsuke.ooyama@bo.or.p Takuya Sugimoo ** No.07-E-4 February 007 Bank of Japan -1-1 Nihonbashi Hongoku-cho, Chuo-ku, Tokyo * Financial Markes Deparmen, Bank of Japan ** Morgan Sanley Japan Securiies (formerly Financial Markes Deparmen, Bank of Japan) Papers in he Bank of Japan Working Paper Series are circulaed in order o simulae discussion and commens. Views expressed are hose of auhors and do no necessarily reflec hose of he Bank. If you have any commen or quesion on he working paper series, please conac each auhor. When making a copy or reproducion of he conen for commercial purposes, please conac he Public Relaions Deparmen (webmaser@info.bo.or.p) a he Bank in advance o reques permission. When making a copy or reproducion, he source, Bank of Japan Working Paper Series, should explicily be credied.

2 The deerminans of credi spread changes in Japan February 007 Financial Markes Deparmen, Bank of Japan Shinsuke Ohyama and Takuya Sugimoo Absrac In his paper, we examine he relaionship beween credi spread changes in Japan and financial and macroeconomic variables such as he risk-free ineres rae and sock price indices. We use a model ha belongs o he class of so-called srucural models for corporae bond pricing originally developed by Meron (1974) and exended by Longsaff and Schwarz (1995) among ohers. Our empirical resuls indicae ha credi spreads in Japan are negaively correlaed wih he risk-free ineres rae and wih corporae financial condiions (which sand proxy for he marke valuaions of firms). The magniude of such correlaions increases as he credi raings of he bond issuers decline. These resuls are consisen wih he implicaions of srucural models and wih he relaed lieraures in he U.S. and Europe. We also find ha credi spreads in Japan are posiively correlaed wih he implied volailiy of ineres raes. In oher words, an increase in uncerainy abou fuure ineres-rae conribues o he widening in credi spreads. We hank Fumihio Gooh (UBS Securiies Japan Ld.), Yasunobu Kasuki (Mizuho Securiies Co., Ld.), Koei Takahashi (Nomura Securiies Co., Ld.), Hideoshi Ohashi (Morgan Sanley Japan Securiies Co., Ld.), and Kiyooshi Yasuda (JPMorgan Securiies Japan Co., Ld.) for heir insighful commens and suggesions. This research is also indebed o discussions wih and commens from our colleagues a he Bank of Japan, especially Yoshifumi Hisada, Yuko Kawa Keii Kono, Teppei Nagano, Nobuyuki Oda, and Youichi Ueno. The views expressed here are ours alone, and do no necessarily reflec hose of he Bank of Japan or oher organizaions. Corresponding auhor, Financial Markes Deparmen, Bank of Japan ( shinsuke.ooyama@bo.or.p) Morgan Sanley Japan Securiies Co. Ld. (formerly Financial Markes Deparmen, Bank of Japan)

3 1. Inroducion 1.1. Moivaion The primary marke for corporae bonds in Japan grew rapidly in he lae 1990s. Two causal facors can be idenified. One is he aboliion of regulaory consrains on corporae bonds, including Issue Sandards. The oher is he decline in he lending capaciy of he Japanese banks caused by a maor disurbance o he financial sysem. Along wih he growh in he issue of corporae bonds, a secondary marke for bonds has developed since hen. Price quoaions in he marke have been publicly observable since he middle of 1997 (see Figure 1). Figure 1: Credi spreads in Japan Jul- 97 Percenage poins Apr- 98 AA BBB Jan- 99 Oc- 99 Jul- 00 A Apr- 01 Jan- 0 Oc- 0 Jul- 03 Apr- 04 Jan- 05 Oc- 05 Jul- 06 Noes: Yields on bonds wih 5-year mauriy. Raings are hose of Moody's, bu we express hem in he more widely-used forms (for example AAA) raher han hose of Moody's (for example Aaa) in his paper. Source: Japan Securiies Dealers Associaion, 'Over-he-Couner Sandard Bond Quoaions.' The differences beween he yields on corporae bonds and hose on governmen bonds (hereafer he credi spreads ) peaked a he end of he 1990s, a around he firs half of 00, and in early 006. The firs peak corresponds o he emergence of anxiey abou he sabiliy of he financial sysem. The second corresponds o a series of maor domesic and foreign bankrupcies. Credi spreads remained sable and low from 003 o 005. In early 006, he spread of BBB-raed (Baa-raed) bonds widened. The riggers were he maor Leverage-Buy-Ou (LBO) shock and he regulaory acions aken agains he consumer finance indusry. Credi spreads for AA- (Aa-) and A-raed 1

4 bonds also widened o some exen around he ime of he erminaion of he quaniaive easing and zero ineres rae policies of he Bank of Japan. 1 The deerminans of credi spreads, in general, consis no only of firms values (credi risks), bu also of oher facors, such as coupons, covenans, embedded call opions, axaion issues, and liquidiy condiions in he marke. Alhough here are many empirical sudies of he relaionship beween credi spreads and such facors in he U.S. and Europe, no enough empirical sudies of credi spreads in Japan have been underaken for a consensus o emerge. Therefore, we empirically invesigae he role of financial and macroeconomic variables in deermining he dynamics of credi spreads in Japan and conribue o undersanding recen developmens in credi spreads. 1.. Relaed lieraure There are wo maor classes of models used o describe credi spread dynamics: srucural models and reduced-form models. The so-called srucural models are based on opion pricing heory. Meron (1974), Longsaff and Schwarz (1995) and ohers have developed maor srucural models. In a sandard srucural model, i is assumed ha a firm s value follows a sochasic process and he defaul siuaion is one in which he firm s value falls below a cerain hreshold, such as he nominal value of deb. On he oher hand, in a sandard reduced-form model, i is assumed ha he mechanism ha governs a defaul process is unobservable, and ha a laen facor known as defaul inensiy deermines he probabiliy of defaul. In his paper, we apply he srucural model, because i explicily describes he defaul mechanism and enables us o analyze he relaionship beween credi spreads and financial and macroeconomic variables. The sandard framework for a srucural model reas a corporae bond as a synheic asse ha consiss of a long posiion on a risk-free bond and a shor posiion on a pu opion whose underlying asse is he issuer s asse. In his framework, changes in credi spreads correspond o hose in he premium value of pu opions. Therefore, he deerminans of he pu opion value are hose of he changes in credi spreads. Tha is, increases in he firm s value and increases in he risk-free ineres rae 1 Appendix 1 summarizes he hisory of credi spread changes in Japan. For example, Ichiue, Ohoka, and Ueno (006) and Ohashi and Makia (006) presen a differen inerpreaion on he role of ineres raes in affecing Japanese credi spreads from 003 o 006.

5 lower he value of he pu opion and, in urn, cause a narrowing of credi spreads. An increase in he volailiy of he firm s value raises he probabiliy of defaul and hus causes a widening of credi spreads. There are many empirical sudies of srucural models on credi spreads for he U.S. and European markes. For example, Longsaff and Schwarz (1995) find ha credi spread changes in he U.S. are negaively correlaed wih changes in he yields of 30-year governmen bonds and wih changes in he reurns of he corresponding sock prices. They also find ha he lower he credi raing of he bond, he more sensiive he credi spread is o changes in sock reurns. These resuls are consisen wih he implicaions of he srucural models. Duffee (1998) and Collin-Dufresne, Goldsein, and Marin (001) poin ou ha here is a negaive correlaion beween credi spread changes in he U.S. and changes in he level and slope of he U.S. governmen bond yield curve. Collin-Dufresne, Goldsein, and Marin (001) also find ha boh he leverage raios of firms and he implied volailiy of he opions for he S&P100 index are posiively correlaed wih credi spreads. The posiive correlaion wih sock opion volailiy increases as he credi raings of bonds decline. These resuls are also consisen wih he predicions of he srucural model. Van Landschoo (004) sudies credi spreads in he European marke o confirm he validiy of he srucural model. He repors ha he shor-erm ineres rae, he slope of he governmen bond yield curve, and sock reurns are negaively correlaed wih credi spreads, while he implied volailiy of sock opions is posiively correlaed wih credi spreads. These sudies generally suppor he validiy of he srucural models of credi spreads in he U.S. and European markes. However, hey also reveal he shorcomings of he srucural model in he empirical sudy. They poin ou ha he explanaory power of he srucural models is limied and, herefore, i is likely ha facors oher han hose included in he srucural model influence he dynamics of credi spreads. Collin-Dufresne, Goldsein, and Marin (001) indicae ha he single common facor driving he residuals of heir models migh represen some kind of imperfecion of he corporae bond marke. 3

6 Pynnönen, Hogan, and Baen (006) conduc an empirical sudy of a srucural model of he Japanese marke. 3 They examine he responses of he credi spreads of AAA- and AA-raed euro-yen corporae bonds o he yield on he 0-year Japanese governmen bond (JGB), he slope of he JGB yield curve, and he reurns of he NIKKEI 5 index. They obain significanly negaive coefficiens on he JGB yields, as prediced by he srucural model. However, he coefficiens on he slope of he JGB yield curve and on he sock index reurns are posiive, conrary o he predicions of he srucural model. They sugges ha heir choice of sample period (January 1995 o Ocober 1998, which was an excepional period in he Japanese economy ) may explain his perverse resul The feaures and srucure of his paper In comparison wih relaed sudies, our paper has he following feaures. Firs, his paper comprehensively examines he validiy of he srucural model for credi spread changes in Japan. Our daa se includes virually all he available ime series daa from he lae 1990s. Despie he so-called uniqueness of he corporae bond marke in Japan, we find ha credi spread changes in Japan share he same characerisics as hose in he U.S. and Europe. Second, our model incorporaes facors oher han hose included in he sandard srucural model in order o overcome he shorcomings of sandard srucural models idenified in previous sudies. These facors are he implied volailiy of he ineres rae and oher variables relaed o he condiions of corporae bond marke. The empirical resuls reveal ha hese addiional facors have saisically significan influences on he changes in credi spreads. Third, whereas sandard sudies of srucural models uilize sock prices in order o proxy firms values, we use alernaive proxy variables. This is because he sock price index in Japan may bear noises unrelaed o firms values. The alernaive proxies we use are indicaors of he firms financial sandings. We find ha he esimaed coefficiens on hese variables have signs ha are consisen wih model 3 Alhough hey do no explicily use he srucural model, Haor Koyama, and Yoneani (001) and Ichiue, Ohoka, and Ueno (006) analyze he ime series characerisics of credi spreads in Japan. 4

7 predicions. The res of his paper is organized as follows. In Secion, we describe our model, which is a linear represenaion of he srucural model, as well as he daa se. In Secion 3, we repor he empirical resuls, which are based on daily daa. In Secion 4, we develop and explain furher analysis based on he alernaive proxies for firms values. Secion 5 concludes he paper.. Model and daa In he framework of he sandard srucural model, he credi spread is deermined by he firm s value, is volailiy, and he risk-free ineres rae. Because credi spreads are uniquely deermined given he curren values of hese sae variables, i follows ha changes in credi spreads are deermined by changes in hese sae variables. We follow he lieraure, including he sudy of Longsaff and Schwarz (1995), by adoping a linear represenaion of he srucural model. Because he empirical sudies for he U.S. and Europe have idenified poenial shorcomings of he srucural models, we exend he sandard model o incorporae variables ha are relevan in he conex of corporae bond markes, in addiion o hose included in he srucural models. The specificaion of our linear model is as follows: ΔCS ε,, = c ~ N(0, σ 4,, 1, Δσ ) Δr, NKY, 5, ΔTL r Δσ 3, 6, Δ log( TPX Δonoff + ε ), (1) r NKY where CS, c, r, σ, TPX, σ, TL, onoff, and ε denoe he credi spread, he consan, he yield of he JGB, he implied volailiy of ineres raes, he sock price index (TOPIX), he implied volailiy of opions on he sock price index (NIKKEI 5), he LIBOR spread, he premium on he on-he-run JGB, and he residuals, respecively. The subscrips i,, and denoe credi raings, mauriies, and ime, respecively, while Δ and Δ log represen he firs difference and he log difference, respecively. CS, i, is he average of he credi spreads whose credi raings are i and whose mauriy is from o + 1 years. We obain each CS i,, by subracing he JGB 5

8 yield wih mauriy from he corresponding yields of corporae bonds. The daa on corporae bond yields are published by he Japan Securiies Dealers Associaion. 4 Our daa se consiss of he series wihou any missing daa in he sample period. 5 Noe ha because CS i,, is an aggregae based on credi raing and mauriy, changes in CS i,, may reflec changes in credi raings and mauriies, issues of new bonds, and changes in credi raing policy. r, is he yield on he JGB wih a -year mauriy, which is inerpolaed from JGB prices in he secondary marke. The srucural model suggess ha an increase in he risk-free ineres rae narrows credi spreads. Therefore, he expeced sign of is negaive. 6 We assume ha here is no srong negaive correlaion beween he risk-free rae and he firm s value. Typically, an increase in he risk-free rae is accompanied by an increase in he real growh and he inflaion rae; under such circumsances, firms values also increase. This casual observaion suggess a posiive correlaion beween he risk-free ineres rae and firms values. However, if an increase in he risk-free rae lowered he firm s value and, in urn, widened he credi spread, hen he coefficiens of r, could be posiive. Even if his correlaion were negaive, wheher he coefficiens of r, are negaive depends on he size of he correlaion or on he volailiy of he firm s value. 7 We evaluae he appropriaeness of our assumpion by inerpreing he esimaion resuls. r The implied volailiy of ineres raes, σ, is measured by he implied volailiy r of he swapion on 10-year swap rae wih one-monh opion period. We inerpre σ as a proxy for uncerainy abou fuure ineres rae. We assume ha invesors in corporae bonds are risk averse and have unmached duraion of asses and liabiliies in heir balance shees. Then, an increase in uncerainy abou fuure ineres rae makes r, 4 The credi raings are hose of Moody s, which are caegorized ino Aaa (corresponding o AAA in his paper), Aa (AA), A (A), Baa (BBB), and Ba (BB). 5 We seleced one-year, wo-year, hree-year, five-year, seven-year, and nine-year yields for AA- and A-raed bonds, and one-year, wo-year, hree-year, and five-year yields for BBB-raed bonds. 6 We assume ha r, proxies he spo rae of he risk-free rae. I is likely, however, ha r, conains informaion abou he slope of he JGB yield curve as well as informaion abou he level of risk-free ineres rae. This is because r, is he JGB yield wih a mauriy of more han one year. 7 Longsaff and Schwarz (1995) presen an illusraive example in which he coefficien on r, is negaive, even hough he correlaion beween he ineres rae and firms asse values is negaive. 6

9 invesmen in corporae bonds less aracive and hereby widens credi spreads. In r oher words, he coefficien on σ is expeced o be posiive. The sock index (TOPIX), TPX, and he implied volailiy of sock reurns (he NKY NIKKEI 5 index), σ, proxy firms values and heir volailiy, respecively. 8 The former is prediced by he srucural models o have a negaive coefficien; he coefficien of he laer is expeced o be posiive. TL is he 10-year LIBOR spread over he yield of he 10-year JGB. Collin-Dufresne, Goldsein, and Marin (001) consider he LIBOR spread as a proxy for liquidiy in he corporae bond marke, because if liquidiy in he swap marke dries up, i seems plausible ha liquidiy in he corporae bond marke will dry up as well. Noe ha inerpreing he role of TL in credi spread changes is no sraighforward. One of he reasons is ha he LIBOR spread reflecs no only liquidiy in he financial marke, bu also reflecs he risk premium for he banking secor. Because corporae finance in Japan has relied heavily on he banking secor, he financial healh and srengh of he banking secor may affec credi spreads in nonfinancial secors. Anoher reason relaes o he pricing of corporae bonds. Hisorically, in Japan, he prices of BBB-raed bonds, and some A-raed bonds, have been based on he yield quoed over he LIBOR. Therefore, he credi spreads on hese bonds, measured in erms of differences from he JGB yield, incorporae changes in he difference beween he LIBOR and he JGB yield. However, whaever mechanism is involved, he coefficien on TL is expeced o be posiive. The variable onoff is calculaed as he yield on he newly issued (on-he-run) 0-year JGB minus he yields on previously issued (off-he-run) bonds. Following Collin-Dufresne, Goldsein, and Marin (001), we inerpre onoff as an indicaor of he liquidiy condiions in bond markes overall. Normally, he on-he-run bonds are raded more frequenly han he off-he-run bonds; hence, onoff reflecs a premium for liquidiy. In oher words, a decrease in onoff corresponds o an increased preference for bond liquidiy, which widens credi spreads. Thus, he coefficien of onoff is expeced o be negaive. 8 NKY σ is he average of he implied volailiies of he a-he-money call and pu opions in he NIKKEI 5 index. We used he opions on he NIKKEI 5 raher han hose on TOPIX because of daa availabiliy. 7

10 As equaion (1) indicaes, we esimae he model in firs differences. 9 We use daily daa from December 1 s, 1998 o Augus 5 h, 006. The esimaion mehod is he Ordinary Leas Squares. 3. Esimaion resuls based on daily daa JGB yields In his secion, we repor and inerpre he esimaion resuls of equaion (1) on daily daa. We sar wih he responses of changes in credi spreads o changes in JGB yields. Mos of he esimaed coefficiens on he JGB yields ( Δ ) in equaion (1), β 1,, are saisically significan and negaive, which is consisen wih he predicions of he srucural model (see Table 1). 11 These resuls imply ha a srong negaive correlaion beween he risk-free ineres rae and firms values is unlikely. r, Table 1: Coefficiens on JGB yields: β 1, i AA ( 1.18) (7.30) (.76) 0.08 ( 4.4) ( 17.54) ( 15.88) A 0.68 ( 13.90) 0.06 ( 1.68) ( 4.46) ( 11.98) ( 16.19) ( 13.71) BBB ( 15.04) (.35) ( 5.58) ( 8.79) Noes: Numbers in parenheses are -values. Shaded cells conain esimaed coefficiens ha are saisically significan and of he expeced signs. 9 We esimae in firs differences because we canno reec he hypoheses ha CS i,,, r,, and TPX have uni roos. 10 Deailed esimaion resuls are presened in Appendix. 11 There may be oher inerpreaions of hese resuls. One is ha he negaive coefficiens merely reflec he difference in efficiency beween he corporae bond and JGB markes. If he corporae bond marke does no absorb a shock as quickly as he JGB marke, he esimaed coefficien on r, could be negaive. However, we inerpre he resuls no only in erms of coefficien signs, bu also in erms of he relaive magniude of he responses. The relaive magniudes of he esimaed coefficiens across mauriies and credi raings also suppor he validiy of he srucural model. 8

11 A closer look a Table 1 shows ha he absolue values of all he coefficiens on one-year bonds are larger han hose on he longer mauriy bonds. This resul may have arisen from he mismach in mauriies beween CS i, 1, and r 1,. While CS i, 1, measures he spread for corporae bonds wih mauriies of beween one and wo years, r 1, is he inerpolaed yield of he JGB wih a exac one-year mauriy. During he sample period, he shor-erm ineres raes were approximaely zero due o he Bank of Japan s policy. For his period, he slope of he JGB yield curve for one-year mauriy is relaively seep. These unmached mauriies may have generaed he high sensiiviy of CS i, 1,. 1 Anoher ineresing feaure of Table 1 is he relaive magniudes of coefficiens for bonds wih mauriies of wo or more years. The longer he mauriies, or he lower he credi raings, he larger he relaive magniudes of he coefficiens are. This resul is consisen wih he predicions of srucural models, as poined ou by Longsaff and Schwarz (1995) and Duffee (1998) The implied volailiy of he ineres rae Mos of he coefficiens, β,, on he implied volailiy of ineres raes as r measured by he swapions ( Δ σ ) are saisically significan and posiive (see Table ). This resul clearly indicaes ha an increase in uncerainy abou fuure ineres rae widens credi spreads. 1 An alernaive inerpreaion relaes o he limiaions of he srucural models. As poined ou in he lieraure, he srucural models do no adequaely explain he credi spreads of bonds wih shor mauriies, because hey assume a coninuous process for firms values and preclude sudden defaul. However, he reduced-form model and he srucural model exended o incorporae a ump process for he firm s value beer explain he credi spreads of bonds wih shor mauriies. 13 They also poined ou ha he negaive relaionship weakens when mauriy lenghens beyond a cerain period. 9

12 Table : Coefficiens on he implied volailiy of ineres raes: β, i AA (11.13) (7.59) (5.88) (3.06) (3.04) (1.44) A (8.19) (5.8) (4.36) (4.06) (.8) (1.55) BBB (8.15) (6.68) (4.10) (.3) Noes: Numbers in parenheses are -values. Shaded cells conain esimaed coefficiens ha are saisically significan and of he expeced signs. In each row, shorer mauriies are associaed wih larger esimaed coefficiens. One inerpreaion is ha invesors in corporae bonds prefer longer mauriies in order o miigae duraion mismaches in heir balance shees. In heory, if he duraions of asses and liabiliies are perfecly mached, changes in he risk-free rae do no influence he ne reurns of invesors. In pracice, however, i is rarely feasible o mach he duraions of asses and liabiliies perfecly. If invesors in corporae bonds have liabiliies wih long duraions, hey end o prefer corporae bonds wih longer mauriies. Increased holdings of asses wih longer mauriies help o reduce he degree of duraion mismach, and in urn reduce he influence of changes in he risk-free ineres rae. The primary invesors in corporae bonds in Japan are insiuional invesors, such as life insurance companies and pension funds. Because he duraions of heir liabiliies are longer han hose of heir asses, i is consisen wih he above inerpreaion o sugges ha hese invesors prefer corporae bonds wih longer mauriies and hus buy and hold primary issues. There is anoher inerpreaion of he finding ha he credi spreads wih shorer mauriies are associaed wih larger esimaed coefficiens. I is based on he idea ha he implied volailiies of ineres rae opions diminish as mauriies increase. One probable explanaion of his is ha he influences of realized and prediced shocks are less significan for long mauriies han for shor mauriies. Hence, credi spreads of longer mauriy corporae bonds may incorporae less uncerainy abou fuure ineres rae on an annualized basis. 10

13 3.3. Firms values The esimaed coefficiens on he reurns of TOPIX ( Δ log( TPX )), β 3,, are saisically significan and posiive in mos cases (see Table 3). This resul is inconsisen wih he predicions of he srucural models, bu consisen wih he findings of Pynnönen, Hogan, and Baen (006) for euro-yen bonds. Table 3: Coefficiens on he reurns of TOPIX: β 3, i AA (1.5) (.54) (.60) (.18) (.36) (0.89) A 0.06 (1.61) (.74) (.11) (.43) (0.93) 0.04 (1.4) BBB 0.04 (1.39) (.7) (.69) (.67) Noes: Numbers in parenheses are -values. In he conex of he implied volailiy of he NIKKEI 5 index ( coefficien, β 4,, is saisically significan (see Table 4). Δ NKY σ ), no Table 4: Coefficiens on he implied volailiy of he NIKKEI 5 index: β 4, i AA (0.53) (1.14) (1.57) (0.50) (1.04) (1.6) A (0.8) (1.41) (0.95) ( 0.40) ( 0.5) (1.6) BBB (0.56) (0.1) (1.16) ( 0.58) Noe: Numbers in parenheses are -values. These resuls imply ha he aggregae sock price indices are inappropriae proxies for firms values in Japan. Alhough he cause of hese resuls is unclear, possible explanaions include aggregaion bias in sock price indices, differences beween firms covered by sock price indices and firms covered by our measuremens of credi spreads, and he lack of nonarbirage condiions beween he prices of socks and 11

14 corporae bonds. We leave furher invesigaion of his issue for fuure research. In Secion 4, we uilize alernaive proxies o examine he role of firms values in deermining credi spread changes Oher variables relaed o he corporae bond marke There remain wo variables o be discussed in our esimaion: he LIBOR spreads and he on-he-run JGB premiums. For he LIBOR spreads ( Δ TL ), mos of he coefficiens, β 5,, are saisically significan and posiive, as expeced (see Table 5). Table 5: Coefficiens on LIBOR spreads: β 5, i AA ( 1.36) (0.7) (3.37) (3.57) (.41) (4.84) A ( 1.54) (1.8) (5.03) (7.00) (5.4) (7.76) BBB (.1) (.05) (5.0) (4.40) Noes: Numbers in parenheses are -values. Shaded cells conain esimaed coefficiens ha are saisically significan and of he expeced signs. In each column, he coefficiens on he AA-raed bonds are smaller han hose on he A- and BBB-raed bonds. In each row, he coefficiens increase in general as mauriies lenghen. One inerpreaion of hese resuls is ha he lower he credi raing, or he longer he mauriy, he more sensiive he price of he corporae bond is o changes in marke liquidiy condiions. Given ha he LIBOR spreads represen evaluaions on he soundness of he banks financial sandings, we can inerpre hese resuls in he following way; he lower he credi raing of he debor, or he longer he mauriy of he deb, he greaer he effec is from he financial condiions of he banks (lenders ) on he credi spread of he debor. The coefficiens on he on-he-run governmen bond premium ( Δ onoff ), β 6,, are saisically significan and negaive for AA-raed bonds and for mos A-raed bonds, bu are no significan for he BBB-raed bonds, excep he one-year ones (see Table 6). 1

15 Table 6: Coefficiens on he on-he-run governmen bond premium: β 6, i AA ( 3.17) (.30) ( 3.10) ( 5.09) ( 4.07) (.10) A ( 4.11) (.40) 0.17 (.3) ( 1.80) (.13) ( 1.6) BBB 0.19 ( 3.18) ( 1.87) ( 1.56) ( 1.34) Noes: Numbers in parenheses are -values. Shaded cells conain esimaed coefficiens ha are saisically significan and of he expeced signs. These resuls are consisen wih he finding of Churm and Panigirzoglou (005) ha corporae bonds wih higher credi raings are sensiive o he liquidiy of he governmen bond marke because AA- or A-raed bonds are, o some exen, reaed as alernaives o corporae bonds Wha do we know from he empirical resuls based on daily daa? Among he variables from he srucural models, only he risk-free rae, Δ, has coefficiens of he expeced sign. Coefficiens on he sock price, Δ log( ), and TPX r, is implied volailiy, NKY Δ σ, have signs ha conradic he predicions of he srucural model. Among oher variables incorporaed in his paper, he implied volailiies of ineres raes, r Δ σ, have saisically significan and posiive coefficiens. This resul indicaes ha increased uncerainy abou fuure ineres rae widens credi spreads. I is consisen wih our expecaion ha mos of he esimaed coefficiens on Δ TL and Δ onoff are saisically posiive and negaive, respecively. This suggess ha financial condiions surrounding corporae bond marke are also ones of deerminans of credi spread changes in Japan. Noe ha he goodness-of-fi measures (he adused R s) for he model are poor regardless of he credi raings and mauriies, which is in line wih sudies of he U.S. and European markes (see Table 7). These resuls sugges ha oher facors no incorporaed in our model influence changes in credi spreads. 13

16 Table 7: Adused R s and Durbin Wason saisics i Adused R Durbin Wason sa. AA A BBB Esimaion based on alernaive proxies for firm s values As shown in Secion 3, he sock price indices are no suiable proxies for firms values in Japan. In his secion, we adop he following hree variables as alernaive proxies for firms values: he revision index of corporae earnings forecass; profiabiliy indicaors; and he financial posiions of firms. Because i is no possible o observe all of hese variables on a daily basis, we use monhly daa o esimae he model. We firs reesimae equaion (1) by using monhly daa as he preliminary sep in he analysis. According o he resuls, 14 he coefficiens on Δ r,, Δ TL, and Δ onoff are insignifican when monhly daa are uilized, bu are saisically significan based on he daily daa. This suggess ha he effecs of hese hree variables are oo small o be r exraced on a monhly basis. On he oher hand, he esimaed coefficien on Δ σ is saisically significan and posiive even when monhly daa are used. Thus, we uilize r Δ σ in he monhly model. The specificaion of he monhly model is as follows: ΔCS, = a 1 + γ 11 Δσ r + γ 1 RI 1 + u, u, ~ N(0, σ 1,, ) ΔCS i,, = a i, + γ 1 i, Δσ r + γ i, ΔROA 3 + ν, ν, ~ N(0, σ,, ) () ΔCS, = a 3 + γ 31 Δσ r + γ 3 ΔDI 1 + o, o, ~ N(0, σ 3,, ) r where CS, σ, RI, ROA, and DI denoe he credi spread, he implied volailiy of ineres raes, he revision index of he earnings forecass, he reurn on asses, and he diffusion index for corporae financial posiions, respecively. The subscrips i,,, and Δ are he same as hose in equaion (1). 14 Deails are in Appendix 3. 14

17 RI is he revision index of he corporae earnings forecass published by Toyo Keizai Inc.. The definiion of RI is given in equaion (3). Daa on RI is released monhly and we use a one-monh lag o adus for he iming of he daa release. ( Number of upward revisions - Number of downward revisions) RI = 100 (3) Number of corporaions covered ROA is he reurn on he oal asses of all indusries from he Financial Saemens Saisics of Corporaions by Indusry (obained from he Minisry of Finance). We seasonally adus he original quarerly daa by using he X 11 mehod and linearly inerpolae he monhly daa. We use a hree-monh lag of his variable for esimaion. DI is he diffusion index of he financial posiions of all indusries in TANKAN released by he Bank of Japan. DI is a summary of he index of inside-and-ouside udgmens of firms financial posiions, which relae o, for example, he level of cash and he lending aiudes of banks. Given ha he original index is released on a quarerly basis, we linearly inerpolae he monhly daa. The lag used in esimaion is one monh. Over ime, hese hree variables have behaved similarly (see Figure ). This casual comparison suggess ha hese variables are influenced by a common facor. We assume ha his common facor represens movemens in firms values Figure : Three proxy variables for corporae financial condiions % Financial Posiion DI ROA (righ-scale) M-97 M-98 M-99 M-00 M-01 M-0 M-03 M-04 M-05 M

18 (Figure coninued) 50 Percenage poins Revision Index ROA (monhly changes, righ-scale) M-97 M-98 M-99 M-00 M-01 M-0 M-03 M-04 M-05 M-06 Sources: Toyo Keizai Inc., Minisry of Finance, and Bank of Japan ROA and CS, i The variables, and r CS,, and σ r are defined as in Secion 3. Because daa on i DI are released wihin he firs 10 days of each monh, we use he daa on σ corresponding o he 10 h day of each monh. 15 Table 8-1 o 8-3 summarizes he esimaion resuls. 16 Mos of he esimaed coefficiens on he proxies represening he financial condiions of firms are saisically significan and negaive, as prediced by he srucural models. Closer inspecion of Table 8 shows ha he coefficiens for BBB-raed bonds are more significan and are larger han hose for AA- and A-raed bonds. Table 8 1: Coefficiens on he revision index: 1 γ i AA ( 1.7) ( 1.8) ( 1.0) ( 1.91) ( 1.38) ( 0.78) A ( 1.73) ( 1.87) (.4) (.44) (.4) (.55) BBB ( 3.69) ( 4.03) ( 3.50) (.74) Noes: Numbers in parenheses are -values. Shaded cells conain esimaed coefficiens ha are saisically significan and of he expeced signs. 15 If he marke is closed on he 10 h, we used daa on he previous business day insead. 16 Deails are in Appendix 4. 16

19 Table 8 : Coefficiens on ROA: γ i AA 0.96 (.54) 0.08 ( 1.64) ( 0.70) 0.15 ( 1.78) ( 1.08) ( 1.04) A ( 3.48) (.41) ( 1.8) (.4) 0.37 ( 1.03) ( 1.55) BBB ( 3.55) ( 3.49) (.17) ( 3.15) Noes: Numbers in parenheses are -values. Shaded cells conain esimaed coefficiens ha are saisically significan and of he expeced signs.. Table 8 3: Coefficiens on financial posiions, DI: 3 γ i AA ( 1.06) ( 1.13) ( 0.84) ( 1.6) (.07) ( 1.67) A ( 1.79) ( 3.5) ( 3.01) ( 3.54) (.81) ( 4.10) BBB ( 4.67) ( 4.93) ( 4.8) ( 3.09) Noes: Numbers in parenheses are -values. Shaded cells conain esimaed coefficiens ha are saisically significan and of he expeced signs. The sandard srucural model implies ha he lower he credi raing (ha is, he closer he firm s value is o he defaul hreshold), he more sensiive credi spreads are o changes in he firm s value. Our resuls are consisen wih his implicaion. The adused R s indicae ha hese models fi beer han hose of Secion 3, paricularly for BBB-raed bonds (see Table 9). Thus, hese resuls seem o suppor he appropriaeness of he alernaive proxies for firms values. 17

20 Table 9: Adused R s and Durbin Wason saisics Revision index i Adused R Durbin Wason sa. AA A BBB ROA i Adused R Durbin Wason sa. AA A BBB Financial posiions, DI i Adused R Durbin Wason sa. AA A BBB Conclusion 5.1. Summary of findings In his paper, we invesigaed he relaionship beween changes in credi spreads and changes in financial and macroeconomic variables in Japan. We obained several ineresing findings. Firs, we found he evidence o suppor he validiy of srucural models in Japan. 18

21 Among he variables incorporaed in he srucural models, he change in he risk-free rae has a saisically significan and negaive correlaion wih changes in credi spreads. This resul is consisen wih he predicions of sandard srucural models and wih empirical sudies on he U.S. and European markes. Our sudy also suggess ha sock price indices may no be appropriae proxies for firms values in Japan. When we incorporaed indices of he financial condiions of firms insead of using sock price indices, we obained resuls compaible wih he predicions of he srucural models; ha is, an increase in firms values narrows credi spreads. The empirical resuls indicae ha he lower he credi raings, he more sensiive changes in credi spreads are o changes in he ineres rae and changes in firms values. This is consisen wih he U.S. and European evidence. Second, we adoped several variables oher han hose included in sandard srucural models o overcome he shorcomings of he srucural models. The implied volailiy of swapions has a saisically significan and posiive correlaion wih credi spreads. This resul is consisen wih he percepion of marke paricipans ha he increased uncerainy abou fuure ineres raes widens credi spreads. Changes in he LIBOR spread and changes in he on-he-run premiums of JGBs have saisically significan effecs on he daily dynamics of credi spreads. Credi spreads wih higher credi raings respond less o he LIBOR spread and more o he on-he-run premiums of he JGBs. These influences on credi spreads are less apparen from monhly daa. 5.. An inerpreaion of he dynamics of credi spreads since 003: he role of moneary policy Using he empirical resuls repored in his paper, we inerpre he developmen of credi spreads from 003 o 006. There are wo maor explanaions of he role of moneary policy in generaing narrow and sable credi spreads. Firs, he hisorically low level of ineres raes under he quaniaive easing policy conribued o lower credi spreads. This assumes ha here is a posiive correlaion beween credi spreads and he risk-free ineres rae. Second, one source of narrow and sable credi spreads is reduced uncerainy abou fuure ineres rae under he quaniaive easing policy. 19

22 Our empirical resuls, and he predicions of he srucural models, suppor he laer explanaion. In oher words, if he erminaion of he quaniaive easing and zero ineres rae policies raised uncerainy abou fuure ineres rae, hen o some exen, i widened credi spreads. Our sudy suggess ha i is likely ha he coninued improvemen in corporae financial condiions conribued o lowering credi spreads. However, one should be cauious in crediing he role of he quaniaive easing policy. This is because surveys sugges ha he quaniaive easing policy had a limied effec on he real economy. 17 I is also possible o asser ha he quaniaive easing policy reduced uncerainy abou he financial condiions of banks and firms and consequenly lowered credi spreads. However, i is difficul o aribue he narrow and sable credi spreads solely o he effec of he quaniaive easing policy. This is no only because corporae financial posiions behaved over ime in he same way as corporae earnings, bu also because oher policies, such as public recapializaion of he banks, conribued o reducing uncerainy Final remarks In his paper, we showed ha i is appropriae o apply he srucural model developed by Meron (1974), and exended by Longsaff and Schwarz (1995) and ohers, o analyze changes in credi spreads in Japan. Neverheless, our analysis has several shorcomings. Firs, he fi of he empirical models is relaively poor, as are hose fied o he U.S. and European credi spreads. This suggess ha variables oher han hose incorporaed in our sudy have been omied. I is worh adoping proxies for a macroeconomic risk premium on financial sabiliy, given a maor financial disurbance a he end of he 1990s. We also expec proxies for he degree of risk allowances of banks o be effecive because bank loans coninue o dominae corporae finance. Oher candidaes are proxies for he effecs originaed in he primary corporae bond 17 Ugai (006) provides a comprehensive survey of he lieraure on he quaniaive easing policy. Kimura and Small (006) analyze he porfolio rebalancing effecs of he quaniaive easing policy on credi spreads. 0

23 markes. Marke paricipans poin ou ha a large bond issue of new corporae bonds can widen credi spreads in he secondary marke. Second, alhough we uilized a linear version of he srucural model, he relaionship beween credi spreads and financial and macroeconomic variables may be nonlinear. In he sandard srucural model, he magniude of credi spread responses o changes in ineres raes depends on he degree of financial leverage (measured by he raio of oal asses o capial) of firms. Third, because he credi spreads analyzed in his paper are averages of spreads caegorized by credi raing and mauriy, our resuls may be affeced by raings changes or by changes in raings policy. In addiion, because we used financial and macroeconomic variables o proxy firms values, hese proxies incorporae informaion on firms who do no issue corporae bonds. I is necessary o analyze he dynamics of credi spreads by using disaggregaed daa for a fixed sample. Finally, i is imporan o analyze he exen and influence of he srucural changes in Japan s corporae bond marke. Recenly, here has been he emergence of he CDS marke and changes in he behavior of insiuional invesors. We leave hese issues for a fuure research. References Churm, Rohan and Nikolaos Panigirzoglou (005), Decomposing Credi Spreads. The Bank of England Working Paper 53. Collin-Dufresne, Pierre, Rober S. Goldsein, and J. Spencer Marin (001), The Deerminans of Credi Spread Changes. Journal of Finance 56, Duffee, Gregory R. (1998), The Relaion beween Treasury Yields and Corporae Bond Yield Spreads. Journal of Finance 53, 5 4. Haor Masazum Koi Koyama, and Tasuya Yoneani (001), Analysis of Credi Spreads in Japan s Corporae Bond Marke. BIS Papers No. 5. Ichiue, Hibik Eiko Ohoka, and Youichi Ueno (006), Credi Spread ni Eikyou wo Oyobosu Macro Youin ( Macroeconomic Facors Influencing Credi Spreads ), in Japanese. Bank of Japan Review Series 06 J 06. 1

24 Kawa Yuko and Masanori Yukawa (005), Kokunai Koubo Fuu Shasai Shio niokeru Spread no Douko ( Spread Behavior of Sraigh Corporae Bonds in Japan ), in Japanese. Unpublished manuscrip. Kimura, Takeshi and David Small (006), Quaniaive Moneary Easing and Risk in Financial Asse Markes. Topics in Macroeconomics 6. Longsaff, Francis A. and Eduardo S. Schwarz (1995), A Simple Approach o Valuing Risky Fixed and Floaing Rae Deb. Journal of Finance 50, Meron, Rober C. (1974), On he Pricing of Corporae Deb: The Risk Srucure of Ineres Raes. Journal of Finance 9, Ohash Hideoshi and Kiyoaka Makia (006), Weekly Credi Sraegy no Shien, January 30 h 006 ( Viewpoins of Weekly Credi Sraegies, January 30 h 006 ), in Japanese. Morgan Sanley Japan Securiies Co., Ld. Pynnönen, Seppo, Warren P. Hogan, and Jonahan A. Baen (006), Dynamic Equilibrium Correcion Modelling of Yen Eurobond Credi Spreads, IIIS Discussion Paper Series 17. Shima, Yoshio (006), Nippon no Credi Shiou ( Credi Markes in Japan ), in Japanese. SIGMA BASE CAPITAL Corporaion. Uga Hiroshi (006), Effecs of he Quaniaive Easing Policy: A Survey of Empirical Analyses, Bank of Japan Working Paper Series 06 E 10. Van Landschoo, Asrid (004), Deerminans of he Euro Term Srucure of Credi Spreads. European Cenral Bank Working Paper Series No.397. Yasuda, Kiyooshi (00), Ippansai Torihiki Nyumon ( Inroducion for Trading Non-JGB Bonds ), in Japanese. Pan Rolling Inc.

25 Appendix 1 Credi spread changes in Japan since The primary marke for corporae bonds in Japan expanded in he lae 1990s. Two facors drove he growh of he corporae bond marke. One is he aboliion of he regulaory consrains on primary markes including Issue Sandards. The oher is he decline in he lending capaciy of he Japanese banks, given financial disurbances. Along wih he growh in he issues of corporae bonds, he secondary marke for corporae bonds has developed subsanially. The price quoaions in he marke have been publicly observed since ha ime (see Figure). The differences beween he yields of corporae bonds and hose of governmen bonds (hereafer, credi spreads) have peaked hree imes: a he end of he 1990s, around 00, and in he middle of 006. Here, we review he movemens in credi spreads chronologically. (Figure) Credi spreads in Japan Jul- 97 Percenage poins Apr- 98 AA BBB Jan- 99 Oc- 99 Jul- 00 A Apr- 01 Jan- 0 Oc- 0 Jul- 03 Apr- 04 Jan- 05 Oc- 05 Jul- 06 Noes: Yields on bonds wih 5-year mauriy. Raings are hose of Moody's, bu we express hem in he more widely-used forms (for example AAA) raher han hose of Moody's (for example Aaa) in his paper. Source: Japan Securiies Dealers Associaion, 'Over-he-Couner Sandard Bond Quoaions.' 1. From he end of 1990s o he middle of 001 Credi spreads, especially hose of he banks, widened during he period of 1 This appendix is based on Kawai and Yukawa (006), Shima (006), and Yasuda (00). Appendix1-1

26 financial disurbance riggered by he bankrupcies of he Hokkaido Takushoku Bank and Yamaichi Securiies in November Credi spreads in nonfinancial secors also widened because of he defauls of he Yaohan Corporaion and he JDC Corporaion, and because of a series of credi-raing downgrades. Credi spreads sared o narrow in he middle of 1999 and hen essenially leveled ou unil mid One reason was ha financial disrupion subsided because of he naionalizaion of he Long-erm Credi Bank of Japan and he Nippon Credi Bank in 1998, and because of governmenal recapializaion of he banks. Japan s economic recovery and he consequen improvemens in corporae credi raings also conribued o he urnaround in credi spreads.. From he end of 001 hrough 005 Credi spreads widened dramaically from he end of 001. A leas wo evens drove his widening. One is he defaul of he Mycal Corporaion in Sepember The Mycal case was he firs maor defaul of corporae bonds in Japan ha involved a wide range of insiuional and individual invesors. 5 I was when invesors aenions were araced o he credi risk ha he main bank erminaed is financial suppor o he Mycal Corporaion and riggered is defaul. Anoher even ha widened credi spreads was he bankrupcy of he Enron Corporaion in he U.S.. Because several muual funds, including money marke funds (MMFs), had invesed in he corporae bonds of Enron, and fell below heir par values due o he Enron s bankrupcy, hey were forced o cash ou heir funds and he subordinaed deb of he banks. These sell-ous conribued o widening credi spreads. Furher, i is widely acceped ha oher facors widened credi spreads in his period. Facors included he decrease in he laen profis of he banking secor Yaohan defauled is converible bonds (34.4 billion yen) on Sepember JDC Corporaion defauled is sraigh and converible bonds (50.0 billion yen and 7.1 billion yen, respecively) on December The credi spreads of he A- and BBB-raed bonds widened emporarily and slighly in he laer half of 000, because of a series of bankrupcies (Dai-Hyaku Insurance and Life Corporaion in May, Sogo Corporaion in July, and Chiyoda Insurance in Ocober). 4 The Mycal Corporaion filed he Civil Rehabiliaion Law a firs, bu laer swiched o file he Corporae Reorganizaion Law. 5 Is deb amouned o more han 300 billion yen. Appendix1-

27 because of he fall in sock prices and because of he 9/11 aacks on he U.S. Credi spreads ighened in he middle of 00. Mos banks in Japan had disposed of heir nonperforming loans wih he governmen suppor. Many nonfinancial corporaions had improved heir earnings and financial condiions. Japan s economy showed signs of recovery. The quaniaive easing policy inroduced in March 001 is said o have conribued o lower credi spreads as he uncerainy abou fuure ineres raes had reduced. 3. From he end of 005 o he middle of 006 The BBB-raed spread increased beween he end of 005 and mid-006 because of increasing regulaion of he consumer finance indusry and because of he LBO of Vodafone Japan by Sofbank. The erminaion of he quaniaive easing and zero ineres rae policies is said o widen credi spreads o some exen as he uncerainy abou fuure ineres raes somewha increased. Appendix1-3

28 Appendix Esimaion resuls for equaion (1) based on daily daa ΔCS ε,, = c ~ N(0, σ 4,, 1, Δσ ) Δr eqp,, 5, ΔTL r Δσ 3, 6, Δ log( eqp ) Δonoff + ε, (1) i c β 1 β β 3 β 4 β 5 β 6 Ad. R D.W. AA A (-0.83) (-1.18) (11.13) (1.5) (0.53) (-1.36) (-3.17) (-0.76) (7.30) (7.59) (.54) (1.14) (0.7) (-.30) (-0.65) (.76) (5.88) (.60) (1.57) (3.37) (-3.10) (-0.83) (-4.4) (3.06) (.18) (0.50) (3.57) (-5.09) (-0.93) (-17.54) (3.04) (.36) (1.04) (.41) (-4.07) (-0.99) (-15.88) (1.44) (0.89) (1.6) (4.84) (-.10) (-1.4) (-13.90) (8.19) (1.61) (0.8) (-1.54) (-4.11) (-1.37) (-1.68) (5.83) (.74) (1.41) (1.8) (-.40) (-1.0) (-4.46) (4.36) (.11) (0.95) (5.03) (-.3) (-1.47) (-11.98) (4.06) (.43) (-0.40) (7.00) (-1.80) (-1.3) (-16.19) (.8) (0.93) (-0.5) (5.4) (-.13) (-1.73) (-13.71) (1.55) (1.4) (1.6) (7.76) (-1.6) (-.03) (-15.04) (8.15) (1.39) (0.56) (-.1) (-3.18) (-1.96) (-.35) (6.68) (.7) (0.1) (.05) (-1.87) BBB (-1.16) (-5.58) (4.10) (.69) (1.16) (5.0) (-1.56) (-0.64) (-8.79) (.3) (.67) (-0.58) (4.40) (-1.34) Noe: Numbers in parenheses are -values. Appendix

29 Appendix 3 Esimaion resuls for equaion (1) based on monhly daa ΔCS ε,, = c ~ N(0, σ 4,, 1, Δσ ) Δr eqp,, 5, ΔTL r Δσ 3, 6, Δ log( eqp ) Δonoff + ε, (1) i c β 1 β β 3 β 4 β 5 β 6 Ad. R D.W (-1.97) (3.11) (1.75) (1.1) (0.41) (-0.88) (-1.34) (1.84) (3.66) (1.9) (.40) (-0.46) (0.4) (-0.78) AA (0.53) (.83) (1.1) (.78) (-0.05) (-0.0) (-0.8) (-0.8) (.78) (1.67) (1.57) (0.48) (-.4) (-1.14) (-1.53) (3.63) (0.17) (0.80) (0.80) (-.9) (-0.93) (-3.54) (3.06) (0.89) (-0.3) (-0.46) (-0.3) (-0.87) (-1.3) (3.17) (1.30) (1.39) (-1.39) (-0.1) (-1.35) (0.30) (1.79) (1.18) (.3) (-1.49) (-0.08) (-1.45) A (0.09) (1.6) (-0.53) (.08) (-0.46) (-0.30) (-1.3) (-0.44) (.07) (1.37) (1.39) (-0.19) (-0.4) (-1.76) (-0.5) (1.9) (-1.37) (1.5) (1.54) (0.0) (-1.64) (-0.4) (0.68) (-0.70) (0.53) (1.89) (0.77) (-1.97) BBB (-1.49) (1.88) (0.86) (1.4) (-0.9) (-1.0) (-1.67) (-0.73) (3.18) (0.51) (0.54) (-0.43) (0.07) (-1.34) (0.06) (1.4) (0.03) (1.43) (0.6) (-0.44) (-0.90) (0.47) (0.54) (0.36) (-0.10) (-0.1) (-0.36) (-0.51) Noe: Numbers in parenheses are -values. Appendix 3