Valuing illiquid bonds: how to determine the credit spread?

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What is credit spread and what is its utility?

Credit spread indicates the yield difference between a bond and a "risk-free" financing instrument (government bond) with the same duration and similar characteristics.

How is credit spread useful for valuing illiquid bonds?

When a bond is traded in a market, the price of the instrument is known; however, when the same instrument is not traded, the spread becomes an essential element for estimating the bond's price. In this case, it is often assumed at issuance that the bondholder and the issuer are engaging in a fair transaction. Therefore, it is possible to determine the initial implicit spread. Subsequently, this spread fluctuates throughout the life of the bond, taking into account changing market conditions and issuer risk.

How to determine it?

First step: calculating the issuer's credit score

Using complex and sophisticated models, rating agencies assess the creditworthiness and credit risk of companies. While these agencies cover large corporations relatively well, there is a gap in credit analysis for small and medium-sized enterprises. Alternative sources to rating agencies may still be available (for example: Banque de France). It is also possible to rely on methodologies similar to those used by rating agencies and/or to develop empirical models, particularly using machine learning algorithms and artificial intelligence.

Second step: constructing a spread curve

To construct a credit spread curve, a portfolio of similar listed bonds is typically selected (by maturity, sector, geography, credit score), and it is important to regularly monitor these bonds or relevant indices to reflect market trends. The more heterogeneous this portfolio is in order to obtain a sample close to the bond being valued, the more challenging it becomes to extract reliable data.

In conclusion...

To obtain an initial estimate of the credit spread, one must first use a relative issuer scoring and then match it with theoretical portfolio spreads. However, this estimate can be refined by considering other secondary parameters (such as the specifics of the bond contract and liquidity premium).