Level 3 Assets and Credit Risk

May Xiaoyan Bao and Yixin Liu ()
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May Xiaoyan Bao: Department of Accounting and Finance, Peter T. Paul College of Business and Economics, University of New Hampshire, USA
Yixin Liu: Department of Accounting and Finance, Peter T. Paul College of Business and Economics, University of New Hampshire, USA

Review of Pacific Basin Financial Markets and Policies (RPBFMP), 2018, vol. 21, issue 01, 1-35

Abstract: We examine the impact of Level 3 assets held by nonfinancial companies on credit risk. Specifically, we investigate how the pricing uncertainty of Level 3 assets is reflected in credit ratings, corporate bond yield spreads, and incidences of bond covenants. We find that higher holdings of Level 3 assets are associated with lower credit ratings, higher yield spreads, especially for Level 3 assets sample, and incidences of bondholder-friendly covenants in the bond issues. Our findings are robust to the treatment of sample selection bias and the influence of macroeconomic factors. In addition, our direct test on the relation between the holdings of Level 3 assets and a firm’s distance-to-default shows that higher holdings of Level 3 assets reduce a firm’s distance-to-default. Overall, our findings support the view that Level 3 assets are perceived as increasing credit risk in the bond market.

Keywords: Fair value; Level 3 assets; cost of debt; credit rating; covenants; credit risk (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1142/S0219091518500030

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