Credit spread discrepancies between European rated and unrated corporate bonds

Abstract

OBJECTIVES OF THE STUDY:

As the increasing regulation in the banking industry is pushing Europe towards more vivid capital markets, also an increasing portion of mid-cap companies without official credit ratings are extending their funding sources towards the bond markets. In this thesis, I study whether credit risk is equally well depicted in the prices of European unrated and rated bonds, or whether credit spread discrepancies between the two occur.

DATA AND METHODOLOGY:

In the study, I calculate implied credit ratings for a sample of unrated bonds using three different credit risk models: a shadow rating model provided by Moody's, Altman's Z-Score and the Merton DD model. To assess the accuracy and biasedness of the three models, implied credit ratings are also calculated for a sample of rated bonds. On the basis of the assessment calculations, I conclude that the shadow rating model is unbiased in estimating implied credit ratings, whereas the Merton DD model is somewhat biased to estimate excessively high ratings. The Altman's Z-Score model is completely dismissed due to extremely high inconsistency in rating predictions. After assigning the unrated bonds an implied credit rating, I assess whether their credit spreads are comparatively equal to those of rated bonds with the same level of credit risk and other characteristics. For this, I use simple regression analysis, separately controlling for bond liquidity. The bond samples consist of 237 unrated and 594 rated bonds issued by European listed, non-financial companies during the time period ranging from January 2001 to December 2013.

FINDINGS OF THE STUDY:

The results of the study indicate that the credit spreads of unrated bonds differ from those of rated bonds, i.e. credit risk is not equally accounted for in the prices of these bonds. Interestingly, the results also suggest that unrated bonds with high credit quality, i.e. high implied ratings, have larger credit spreads with regard to their rated counterparts than bonds with lower credit quality, i.e. low implied ratings, do with regard to theirs. In other words, the results imply that investors perceive unrated bonds with high credit quality to be relatively riskier than unrated bonds with low credit quality.