Extrapolating Discount Rates for Illiquid, Low-Rated Companies
Summary
The document asks how to infer an incremental discount rate for a company with no observable traded debt when market yield or credit spread data for its sector stop at stronger credit ratings. Its example is a company rated CCC when available sector data extend only to BB or B. The question is framed in the context of determining a rate such as one used for lease discounting.
It notes that a simple rating-notch extrapolation is questionable because yields do not change linearly across ratings. It also doubts whether a multifactor or deep neural network trained on better-rated issuers can reliably estimate the borrowing cost of a much weaker, illiquid company when relevant data are scarce. The document offers no proposed method, references, or validation evidence; it is an open methodological question about extrapolation risk and the limits of sparse credit data.
Key ideas
- Market yield data may be unavailable for an illiquid issuer at the required credit rating.
- A linear extrapolation across rating notches may misstate yields because the relationship is nonlinear.
- Models trained on stronger-rated firms may not generalize reliably to CCC issuers.
- The document asks for a more rigorous extrapolation method but does not provide one.
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Full text
# Infering the discounting rate for an illiquid company # Infering the discounting rate for an illiquid company Let's say I would like to determine the incremental discounting rate (e.g. as in IFRS-16) for a company $X$ with a rating score of $Y$ and belonging to a sector $Z$. Usually, any data provider such as Bloomberg and Reuters only displays the yields or CDS spreads for some of the sectors and only for liquid ratings: That is, even if the sector $Z$ appears in the Bloomberg/Reuters list, I would only be able to find these rates for ratings all the way down to $BB$ usually, and sometimes even for a $B$ score. The question is the following: If company $X$ has a $CCC$ rating and I only know the yields of the companies of that sector down to a $BB$ (or $B$) rating, how could I infer the yield for such a company? Is there any reference you know where this is treated that you can recommend? I'm also assuming the absence of traded or observable debt for the company. A naive approach would be to use a linear extrapolation down to $CCC$, by notching. However, we know that yields are non-linear in rating, so that could only be used as a dummy extrapolation. I have also seen some DNN/multifactor regressions, but since it's always difficult to harvest data for those kind of companies it feels a bit unnatural to train a DNN on $\left\lbrace AAA, B \right\rbrace$ data, and then use it to price debt on a $CCC$-rated company. I would like to use another idea for that extrapolation (something a bit more rigorous would be ideal). The question is which one, and do you know any reference that supports that assumption?
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