Shadow leverage risk and corporate bond pricing: evidence from China

Abstract

This study investigates the effect of shadow bank leverage on corporate bond returns. Using a unique dataset of Wealth Management Products (WMPs), we construct a new measurement of shadow leverage in the Chinese banking system. We find that the sensitivity of bond returns to the risk of shadow leverage has a negative effect on corporate bond returns. We propose a new three-factor bond pricing model by adding the factor of shadow leverage risk into the traditional two-factor model of Fama and French (1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56). A comprehensive empirical analysis shows that the proposed model fits corporate bond returns well and outperforms the two-factor bond pricing model, both in- and out-of-samples. Specifically, the shadow leverage risk factor makes greater marginal contributions in lower credit rating groups and more shadow leverage-sensitive groups. Overall, we highlight the importance of shadow banks in the role of asset pricing.

KEYWORDS:

• Shadow banks
• leverage risk
• corporate bond
• asset pricing

JEL classifications:

• G10
• G12
• G21

Acknowledgements

We are grateful to two anonymous referees and the editor for their valuable comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 We provide an overview of WMPs in the Chinese market in Appendix A1.

2 We provide an introduction to the Chinese bond market in Appendix A2.

Additional information

Funding

Xu Feng acknowledges to the National Natural Science Foundation of China [grant numbers 71790594, 71871157]. Lin Huang acknowledges to the National Natural Science Foundation of China [grant number 72001157]. Guanying Wang acknowledges to the National Natural Science Foundation of China [grant number 92046024] and Science and Technology Program of Tianjin [grant number 19ZLZXZF00020].