Expanding Horizons in Norwegian High-Yield Bond Spread Estimation : A Comparative Analysis of Structural Bond Pricing Models in the Period 2015 to 2023

Investigating the complex dynamics of credit risk pricing in corporate bonds has been a significant area of interest in financial research for many years. This thesis examines the effectiveness of various structural bond pricing models in predicting credit risk premiums for Norwegian high-yield bonds from 2015 to 2023. Building on the approach by Eom et al. (2004), we compare the predictive accuracy of the extended Merton model with that of the Longstaff & Schwartz (1995) and Leland & Toft (1996) models. Our findings indicate that the extended Merton model tends to underpredict spreads, consistent with prior studies. Additionally, the Leland & Toft model and Longstaff & Schwartz model underpredict spreads, a deviation from existing research. Among these, the Longstaff & Schwartz model emerges as the most precise in predicting spreads for Norwegian high-yield bonds, suggesting the utility of diverse structural bond pricing models beyond the commonly used Merton model. This research, in line with prior empirical studies, highlights a substantial deviation of modeled spreads from actual observed credit spreads, known as the "credit spread puzzle." The thesis attempts to explain the key drivers of this puzzle within the extended Merton model by examining a range of explanatory variables that serve as proxies for liquidity premium and risk premium. Contrary to previous research, our results suggest that the extended Merton model may inherently incorporate a liquidity premium, leaving the credit spread puzzle exclusively to risk premiums. Moreover, we find that the stock price momentum premium is significant in determining credit spreads, whereas neither the market factor size nor the value factor is. We find that the momentum variable may incorporate the effects typically associated with size and that the effect of value is captured by the capital distribution factor. Alongside comparable research, we also discover that high-yield bond investors demand a risk premium for being invested in the sectors of Oil and Gas E&P, Oil and Gas Services, and Shipping. Through this research, it becomes evident that accurately pricing high-yield bonds is a complex endeavor. Particularly challenging is isolating the true essence of the credit spread puzzle, given the potential biases present in both the extended Merton model and the benchmark market spreads.