Department of Industrial Engineering & Decision Analytics [Joint IEDA/MATH seminar] - Priced for Rescue: The Negative Financial Premium in China

Bonds issued by financial firms in China trade at significantly lower credit spreads than comparable bonds issued by non-financial firms. This discount (negative premium) on financial bonds' spreads averages 59 basis points over 2013–2022, is larger for lower-rated and shorter-maturity bonds, and is opposite in sign to the United States. We argue that implicit government guarantees, rather than exposure to systematic risk, drive the negative premium in China. Exploiting the 2019 resolution of Baoshang Bank—the first partial bailout in China’s banking history—as a natural experiment, we find that the negative premium of non-systemically important banks shrinks by about 11 basis points relative to that of systemically important banks. The premium is also wider when credit-market sentiment is poor, and this relation disappears after the Baoshang event. A structural model that combines systematic risk with government bailout accounts for the premium: once we control for the model-implied distance to default, the negative financial premium puzzle is largely resolved.