8.5 Credit Risk, Ratings, and Spreads
Key Takeaways
- Credit risk includes default risk, loss severity risk, downgrade risk, and spread risk.
- Expected loss is commonly analyzed as probability of default multiplied by loss given default.
- Credit ratings summarize relative credit quality, but analysts must still evaluate capacity, collateral, covenants, and business risk.
- Yield spreads compensate investors for credit risk, liquidity risk, tax effects, embedded options, and market risk appetite.
- High-yield bonds have greater credit risk and usually higher required yields than investment-grade bonds.
Credit risk is more than default
Credit risk is the possibility that promised bond cash flows lose value because issuer credit quality weakens. Actual default is the most visible event, but credit risk also includes rating downgrades, spread widening, reduced liquidity, covenant violations, and lower recovery expectations.
A bond investor cares about both the probability of default and the loss if default occurs. A risky issuer with strong collateral may have a lower expected loss than an unsecured claim with similar default probability. Recovery and priority matter.
Expected loss and recovery
A useful credit formula is: Expected loss = Probability of default x Loss given default. Loss given default equals 1 - recovery rate. If default probability is 4 percent and recovery is 40 percent, expected loss is 4 percent x 60 percent = 2.4 percent.
This formula is simplified because timing, discounting, correlation, and changing exposure can matter. For Level I, it anchors the distinction between likelihood of default and severity of loss. Both can change bond value and required spread.
Ratings
Credit rating agencies assign ratings that summarize relative creditworthiness. Investment-grade ratings indicate stronger capacity to meet obligations. Speculative-grade or high-yield ratings indicate weaker credit quality and higher default risk.
Ratings are useful because they standardize credit language and influence investment mandates, capital rules, and benchmark eligibility. They are not a substitute for analysis. Ratings can lag market prices, and two bonds from the same issuer can have different ratings due to priority, collateral, maturity, or structural subordination.
Analysts examine capacity and willingness to pay. Capacity depends on earnings, cash flow, leverage, coverage, liquidity, asset quality, and refinancing access. Willingness can depend on legal structure, sovereign policy, ownership, incentives, and reputation.
Spreads
A yield spread is the extra yield over a benchmark. The benchmark may be a government bond, swap curve, or fitted yield curve. Spreads compensate investors for credit risk, liquidity risk, tax treatment, embedded options, and risk aversion.
The nominal spread is the simple difference between a bond's yield and a benchmark yield of similar maturity. The zero-volatility spread, or Z-spread, is the constant spread added to each spot rate that makes the present value of cash flows equal to market price.
Option-adjusted spread, or OAS, removes the value of embedded options from the spread estimate. For a callable bond, the option benefits the issuer and hurts the investor. The callable bond's nominal spread includes compensation for both credit risk and the call option. OAS tries to isolate the spread after option value.
Covenants, collateral, and priority
Collateral can reduce loss severity if it is valuable and enforceable. Senior secured debt usually has stronger recovery prospects than subordinated unsecured debt. Guarantees can improve credit quality if the guarantor is strong.
Covenants protect creditors by limiting risky actions. Limits on leverage, liens, asset sales, restricted payments, and mergers can reduce value transfer from creditors to shareholders. Weak covenants give issuers flexibility but may require higher spreads.
Structured aid: credit analysis checklist
| Area | Key questions |
|---|---|
| Capacity | Are cash flows enough to cover interest and principal? |
| Leverage | Is debt high relative to EBITDA, assets, or cash flow? |
| Coverage | Are interest and fixed charges covered with margin? |
| Liquidity | Can the issuer fund near-term obligations and maturities? |
| Structure | What are priority, collateral, guarantees, and covenants? |
| Industry | Are revenues cyclical, regulated, concentrated, or disrupted? |
Exam focus
When a spread widens, the bond price falls if other inputs are stable. Spread widening means investors require more compensation. The cause may be issuer-specific deterioration, lower liquidity, weaker market risk appetite, or broader economic stress.
Investment-grade debt usually has lower default probability and lower yield than high-yield debt. High-yield analysis puts more weight on downside, liquidity, covenants, and recovery. For all credit questions, separate default probability from recovery rate and seniority.
Do not assume the highest coupon is the safest bond. A high coupon may be compensation for high credit risk, call risk, illiquidity, or long duration. The safer bond is the one with stronger expected cash flow performance relative to promised payments and legal claim.
A bond has a 3 percent probability of default and an expected recovery rate of 45 percent. The expected loss is closest to:
A widening credit spread, all else equal, most likely causes a corporate bond's price to:
Compared with senior secured debt from the same issuer, subordinated unsecured debt most likely has: