Level 3 Assets and Credit Risk

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.