Corporate Credit Spreads under Parameter Uncertainty

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