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Credit Risk in Japan’s Corporate Bond Market

In recent years, Japan’s major corporations have increasingly relied on the corporate bond market as a source of debt finance. From 1996 to 1998, the issuance of corporate bonds increased more than 46 percent, from 30.8 trillion yen to about 45 trillion yen (Table 1).1 At the same time, loans from Japan’s banking sector decreased about 17 trillion yen. As the corporate bond market grew, the spreads between the yields on Japanese corporate and government bonds widened dramatically. In this edition of Current Issues, we investigate the reasons for the pronounced increase in spreads in Japan’s corporate bond market. We first consider the effect of weak macroeconomic conditions on spreads. Slowed economic growth,. | federal reserve bank of new York CURRENT ISSUES in economics and finance November 1999 Volume 5 Number 15 Credit Risk in Japan s Corporate Bond Market Frank Packer From the fall of1997 to the spring of1999 yield spreads in Japan s corporate bond market increased sharply. An analysis of this rapid rise suggests that Japanese investors in corporate bonds may be paying closer attention to the credit risk of individual issuers. Such a shift in investor focus would represent a major change in the structure of this market. In recent years Japan s major corporations have increasingly relied on the corporate bond market as a source of debt finance. From 1996 to 1998 the issuance of corporate bonds increased more than 46 percent from 30.8 trillion yen to about 45 trillion yen Table 1 .1 At the same time loans from Japan s banking sector decreased about 17 trillion yen. As the corporate bond market grew the spreads between the yields on Japanese corporate and government bonds widened dramatically. In this edition of Current Issues we investigate the reasons for the pronounced increase in spreads in Japan s corporate bond market. We first consider the effect of weak macroeconomic conditions on spreads. Slowed economic growth increased bankruptcies and financial market turbulence helped bring about a decline in the credit quality of Japan s outstanding bond issues. With lower credit ratings suggesting an increased likelihood of future defaults the spreads between the yields on corporate bonds and government bonds widened. Economic and financial conditions however cannot fully account for the rise in spreads. Structural changes in the Japanese bond market also appear to have contributed to the increase in spreads. We uncover two developments that support this view. First bond yields have become increasingly correlated with credit ratings a key measure of credit risk over the past few years. This change suggests that credit risk historically a minor factor in the pricing of .