What is the credit spread and why is it useful?
The credit spread indicates the difference in yield between a bond and a risk-free instrument (government bonds for instance) with the same duration and similar characteristics.
Why is the credit spread useful for valuing illiquid bonds?
When a bond is traded on a market, the price of the instrument is known. However, when the same instrument is not traded, the spread is an essential element in estimating the price of the bond. In this case, it is often assumed at issuance that the bondholder and issuer are making a fair transaction. It is therefore possible to determine the initial implicit spread. Subsequently, this spread fluctuates throughout the life of the bond, as market conditions and issuer risk change.
How do you determine it?
Step 1: 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 cap companies relatively well, there is a void of credit analysis for small/medium cap companies. Alternative sources to rating agencies may though be available (e.g. Banque de France). It is also possible to rely on methodologies similar to those used by rating agencies, and/or to develop empirical models, notably using machine learning and artificial intelligence algorithms.
Step 2: building a spread curve
To build a credit spread curve, a portfolio of similar listed bonds is generally selected (by maturity, sector, geography, credit score), and these bonds or relevant indices are regularly monitored to reflect market trends. The more heterogeneous this portfolio is in order to obtain a sample close to the bond to be valued, the more difficult it is to extract reliable data.
In conclusion…
To obtain an initial estimate of the credit spread, it is first needed to use a relative issuer score and then match it with theoretical portfolio spreads. However, this estimate can be refined by taking into account other secondary parameters (bond contract specificities and illiquidity premium in particular).