Corporate Credit Spreads under Parameter Uncertainty

Abstract:     
This paper assesses the impact of parameter uncertainty on corporate bond
credit spreads. Using data for 5,300 firm-years between 1994 and 2008, we
find that investors’ uncertainty about model parameters explains up to 40% of
the credit spread that is typically attributed to liquidity, taxes and jump risk,
without significantly raising bankruptcy probabilities. Spreads on firms with
large intangible assets and volatile earnings growth are the most affected by
parameter uncertainty. Uncertainty about asset values and volatilities increases
significantly during times of market stress. In particular, the credit crisis of 2008
is characterized by high uncertainty about asset valuations, and parameter
uncertainty alone raised credit spreads by as much as 50 basis points. Our
measures appear to capture a component of uncertainty that is not captured
by proxies used in the literature.

Number of Pages in PDF File: 45

Keywords: Credit risk, credit spread, bankruptcy, default, corporate bonds, MCMC

JEL Classification: G12, G13

working papers series