Understanding Credit Risk of Chinese Companies using Machine Learning: A Default-Based Approach

Abstract

In response to the recent elevated corporate credit risk environment in China, we develop a probability of default (PD) measure based on corporate bond defaults using the machine learning technique. We document a large pricing effect of corporate credit risk based on our PD measure in the primary and secondary corporate bond markets especially following the first bond default in 2014. In the cross section of corporate bond returns, there is a positive credit risk premium even after controlling for common risk factors. Finally, stocks of low PD firms outperform those of high PD firms during the COVID-19 pandemic.

Keywords: Bond market; Credit risk; China; LASSO; Machine learning

JEL Classification: G12; G15; G32; G33