Rating-Based Restriction, Credit Rating Inflation and Bond Covenants - Evidence from Chinese Bond Market

This paper highlights the relation of two independent streams of the literature, the literature on bond covenants and literature on credit rating inflation and addresses how bond covenants are used to inflate bond ratings to comply with regulation on market access. Agency cost theory predicts that bond covenants can decrease the borrowing cost of issuers, especially for low-grade bonds. In contrast to this prediction, our generalized DID estimations find that in the Chinese bond market, investors require a much higher risk premium (180 bps) for AA bonds that are secured with collateral and guarantees than they do for AAA bonds. AA bonds also have worse ex post performance than other bonds, and their issuers engage in more earnings management ex ante than other issuers. More importantly, such an effect clusters in AA bonds, which is the threshold for credit ratings set by regulation. These findings cannot be explained by agency costs, the pay-model of credit rating agencies (CRAs) or competition. This effect is much weaker in a different segmented bond market that is not subject to such rating-based regulation, and we further estimate the deadweight loss of AA bonds (i.e., the marginal bonds most influenced by regulation) to be at least 84 bps.