Corporate Credit Spreads under Parameter Uncertainty
45 Pages Posted: 26 Mar 2008 Last revised: 30 Nov 2009
Date Written: November 27, 2009
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.
Keywords: Credit risk, credit spread, bankruptcy, default, corporate bonds, MCMC
JEL Classification: G12, G13
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