8.5 Credit Risk, Ratings, and Spreads

Credit risk is more than default

Credit risk is the chance that promised bond cash flows lose value because issuer credit quality weakens. It has several dimensions: default risk (the issuer fails to pay), loss severity or recovery risk (how much is lost if default occurs), credit migration / downgrade risk (a rating cut), and market liquidity risk (a wider bid-ask spread). An investor cares about both the probability of default and the loss given default; a risky issuer with strong collateral can have a lower expected loss than an unsecured claim with the same default probability, because recovery and priority differ.

Expected loss and recovery

The core formula is:

Expected loss = Probability of default (POD) x Loss given default (LGD), where LGD = 1 - recovery rate.

Example: POD = 4%, recovery = 40%, so LGD = 60% and expected loss = 4% x 60% = 2.4%. The expression simplifies away timing, discounting, correlation, and changing exposure, but for Level I it anchors the split between likelihood of default and severity of loss; both move bond value and required spread.

Ratings and the four Cs

Credit rating agencies (Moody's, S&P, Fitch) assign ratings that summarize relative creditworthiness. Investment grade runs from Aaa/AAA down to Baa3/BBB-; speculative grade (high yield) is Ba1/BB+ and below. Ratings standardize credit language and drive mandates, capital rules, and benchmark eligibility, but they can lag market prices, and two bonds from one issuer can differ by notching for priority, collateral, or structural subordination.

Analysts assess the four Cs of credit analysis:

Capacity rests on earnings, leverage, coverage, liquidity, and refinancing access; character reflects governance, incentives, and track record.

Spreads

A yield spread is the extra yield over a benchmark (a government bond, swap curve, or fitted curve) that pays investors for credit, liquidity, tax, embedded-option, and market-risk-premium components.

The zero-volatility spread (Z-spread) is the single spread added to every spot rate that makes the discounted cash flows equal the market price. The option-adjusted spread (OAS) strips embedded-option value out of the spread. For a callable bond, the call benefits the issuer and hurts the investor, so the quoted spread mixes credit and call compensation; OAS isolates the credit/liquidity portion: OAS = Z-spread - option cost for a callable bond.

Covenants, collateral, and priority

Collateral cuts loss severity if it is valuable and enforceable; senior secured debt usually recovers more than subordinated unsecured debt. A strong guarantor improves credit quality. Covenants protect creditors by limiting leverage, liens, asset sales, restricted payments, and mergers; weak covenants give issuers flexibility but demand higher spreads.

The priority of claims in default runs, broadly, from first-lien secured debt, to second-lien and senior unsecured, to subordinated debt, and finally to equity. In practice the strict ordering is sometimes violated through negotiated reorganization, so analysts treat the ranking as a strong tendency rather than a guarantee. Structural subordination is a frequent exam trap: debt issued by a parent holding company ranks behind debt at an operating subsidiary, because the subsidiary's own creditors are paid from its assets first and only residual cash flows up to the parent. Sovereign and municipal credit add their own factors.

Sovereign analysis weighs the government's ability and willingness to pay, the difference between local-currency debt (which the state can in principle print to repay) and foreign-currency debt (which it cannot), fiscal balance, external accounts, and political stability. Municipal bonds split into general obligation bonds backed by taxing power and revenue bonds backed only by a specific project's cash flows.

Structured aid: credit checklist

Exam focus

When a spread widens, the required yield rises and price falls, all else equal; causes include issuer deterioration, lower liquidity, weaker risk appetite, or economic stress. Investment-grade debt has lower default probability and lower yield than high-yield debt, where analysis emphasizes downside, liquidity, covenants, and recovery. Always separate default probability from recovery rate and seniority. Do not assume the highest coupon is the safest bond; a high coupon often compensates for high credit risk, call risk, illiquidity, or long duration.

The safer bond is the one with stronger expected cash-flow performance relative to its promised payments and legal claim.