OREANDA-NEWS. Volatility in ChinaBond's high-yield medium-term note (HY MTN) index since mid-November is a result of the index's methodology rather than any spill-over or linkage to recent equity market volatility. The methodology for index composition meant that China Shanshui Cement's securities remained on the index despite a default on its onshore short-term commercial paper and offshore bonds, and that they were allocated a notional yield of 999%, thereby distorting the index.

The index's high volatility underscores the challenges China's index providers face in the nascent MTN market, where the secondary market remains illiquid and there are only a few precedents for default, says Fitch Ratings.

Illiquidity is one factor that hinders price discovery for China's index developers and managers. As a result, the HY MTN index employs prices based on estimates from several sources as well as macroeconomic and regulatory factors. Despite the efforts, an estimate of an illiquid instrument can deviate widely from the actual tradable price. In comparison, international indices constructed by investment banks typically have the banks' sell-side trading desks make a market for the constituents in the indices, and therefore reflect a relatively liquid tradeable price.

The average weighted yield on the ChinaBond HY MTN index, which is published by China Central Depository & Clearing Co. Ltd, a subsidiary of the People's Bank of China, spiked to almost 25% at the end of December before falling to below 10% this week. This was the highest yield recorded in the index since its inception in March 2009. The index covers over 110 MTNs rated below 'AA' by local credit rating agencies.

Overall secondary-market trading liquidity for non-financial corporate bonds in China is thin. Non-financial corporate bonds accounted for less than one-third of the total Chinese bond market at end-2014, with most of them (90%) issued by state-owned enterprises. The HY MTN index tracks a total value of CNY56bn, which is a tiny fraction of the onshore debt market.

Corporate defaults in China are likely to continue to become more common as the authorities move to develop the corporate bond market and issuance grows. Credit spread differentiation is already starting to emerge despite the relative lack of default precedence, with widening yield-to-maturity spreads between higher and lower-rated corporate bonds, as well as between bonds issued by state-owned enterprises (SOEs) and non-SOEs.

Fitch downgraded China Shanshui Cement Group Limited's Issuer Default Rating to 'RD' from 'C' on 11 November following the company's announcement that it filed an application for the appointment of provisional liquidators on 10 November, which constituted a default for the USD500m in offshore notes due 2020. Despite this, Shanshui did not announce a halt to payments for its outstanding MTNs listed on the HY MTN index. As per the methodology of the index, Shanshui's notes remained on the index, though yields were estimated at 999% on 31 December.