Chinese Bond Market Challenges

Sergey N. Smirnov

State University Higher School of Economics Moscow

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Contents:

1 Chinese Bonds Market Overview

3 Applying EFFAS-EBC methodology to Chinese Bonds Market

2 Zero-coupon yield curve used by CGSDTC

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Market scale• About 3000 bonds with total worth 34 704,6

billion RMB issued since 1998

• Currently traded: 1385 bonds with outstanding amount 16 600 billion RMB (rmb usd rate:

1 Chinese yuan = 0.15 U.S. Dollars)

• About 1000 transactions a day with average daily turnaround about 150 billion RMB

• Bonds are traded at Shanghai and Shenzhen exchanges, OTC and inter-bank markets

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Chinese Bonds Market Structure

Source: ChinaBond

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Chinese Bonds Market Structure

Source: ChinaBond

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Market Infrastructure

• The primary market of bond issuance is largely completed through syndication.

• Governmental bonds were mostly underwritten by the four stated-owned banks while other commercial banks and securities companies play active role in forming syndicate to market financial and corporate bonds.

• Most of bonds are held by banks, insurance companies, securities firms, and corporations. Mutual funds hold a relatively small fraction of the total outstanding bonds.

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Instruments Present• Treasure Bonds (Ministry of Finance). All terms. Bullet redemption. Majority has coupons.

• Central Bank Bills (Peoples Bank of China). Very short and short term. Majority are discounted.

• Government owned BanksAll terms. Majority has coupons. Some have options.

• Corporate and Commercial Banks Bonds

• Others

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Outstanding Amount

0

20000

40000

60000

80000

100000

120000

140000

160000

180000

10

0 m

illio

n R

MB

Treasure Bond Central Bank Bills Government owned banks Bonds Corporate Bonds Others

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Current position:

1 Chinese Bonds Market Overview

3 Applying EFFAS-EBC methodology to Chinese Bonds Market

2 Zero-coupon yield curve used by CGSDTC

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History of Zero-Coupon Yield Curves Development in China

• Research (1999-2001). With aid of Reuters was developed first yield curve for Treasure

bonds

• Prototypes (2002-2005). Chinese development of 4 yield curves for Treasure bonds using

information from different markets

• Exploitation and Modification (2006 - Present).

New methods are developed and yield curves are constructed for different types of bonds.

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CGSDTC Methodology

• Data Filtering

• Expert and Historical Estimates

• Hermite Polynomial Fitting

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Data Sources

• Deals Prices from Interbank, OTC and Shanghai Exchange markets

• Bid-Ask Quotes from Interbank market

• Market Participants estimates

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Data Filtering

Visual comparison with historical yield curves, not historical market data

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Expert and Historical Estimates

If too many entries are filtered out the data is augmented with expert estimates or historical

values

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Hermite Polynomial Fitting

• Fix bonds maturity dates as grid nodes

• Fit Hermite polynomial such that:

a) Bond pricing equation holds

b) Yield expert estimates are recovered

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Controversial results

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Current position:

1 Chinese Bonds Market Overview

3 Applying EFFAS-EBC methodology to Chinese Bonds Market

2 Zero-coupon yield curve used by CGSDTC

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Available data

Chinabond has kindly supplied us with the

following data:

– Daily trading results.

– Daily OTC Bid/Ask quotes from 8 banks.

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Quotes co-Movement

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Bid-Ask Spread co-Movement

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Quotes: peculiarities

• Data contains errors: Bid > Ask

• Data is inconsistent: Bids>Askk for several days in a row

• Quoted YTM corresponds to smth slightly less than the Ask quote

• Bid-Ask spread is far too wide

• 4 banks quote all bonds, 4 banks quote only a subset.

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“Best” inter-bank Bid-Ask spreads

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Quotes: Yield Curves

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Quotes: Forward Rates

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Quotes: (Bid+Ask)/2

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Quotes: Summary

• Different banks use different quoting schemes: the way quotes move differs a lot

• Either quotes are non-committing or banks are isolated from each other: systematic arbitrage is present

• Nobody uses spot forward rates

• Bonds are likely to be quoted in groups by time to maturity (duration is not used)

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Prices: peculiarities

• Highly illiquid market

• Prices may lie well outside Bid/Ask quotes

• Similar bonds are frequently priced unlike each other

• No filtering helps since “unusual” prices tend to repeat in time

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Number of Deals

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Turnover

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Price vs. Bid-Ask

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Prices: Yield curves

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More smoothing

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High-Coupon Effect?

• Hypothesis: Chinese traders like high coupons (bonds with high coupons are valued higher).

• Testing: corr(coupon size, spread) = 10%

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Visual Coupons

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Prices: Summary

• Data from different sources are likely to be mixed

• Yield curves should be constructed from quotes

• Extremely illiquid market, price information is unreliable