Assessing the Yield Spread for Corporate Bonds Issued by Private Firms

Abstract

This study assesses the determinants of yield spreads of bonds issued by private firms versus listed firms by applying measures of credit risk applicable to private firms and using real time transactions in estimating liquidity. Corporate bond yield spreads express the compensation that investors require for being exposed to risk related to corporate bonds versus government bonds and derive primarily from liquidity and credit risk. While data for estimating liquidity and credit risk inherent in bond specific characteristics and market conditions is equally available for private and listed firms, the main difference in assessing the yield spreads of their bonds stems from the quality and availability of firm-specific data. This study applies OLS regression analysis and finds that credit risk reflected in sector volatility and leverage is significant for explaining variation in yield spreads of bonds issued by private firms. The model provides a superior fit in terms of a lower SER compared to regressions applying financial ratios to control for credit risk and it is robust to controlling for rating and time fixed effects. Sector values have less explanatory power for bonds issued by listed firms, which suggest that yield spreads of bonds issued by private firms to a higher degree are affected by sector valuations. Publicly traded data is highly significant for the yield spreads of bonds issued by listed firms, explains up to over 30% of their variation and provides superior explanatory power over the data available for private firms. The application of credit risk measures founded on financial ratios provides different results for bonds issued by private and listed firms, which suggest that benchmarking private firms to listed firms in valuing their bonds can lead to erroneous results. While this study finds that there is a significant liquidity premium due to implicit bid-ask spreads, there are no clear indications in terms of the difference in the liquidity component for bonds issued by private and listed firms. Time fixed effects have more explanatory power for yield spreads of bonds issued by private firms than listed firms, which suggest that the valuation of their bonds to a larger degree might be affected by macro economic conditions. This study only considers non-defaulted fixed coupon bullet bonds denominated in USD with maturity between a month and 30 years with transaction data available via Enhanced Trace and accounting data available via Bloomberg. sample used includes 66,165 monthly observations and 12.3% is for bonds issued by private firms.