Subject 1. Credit Risk

Credit risk is the risk of loss of interest and/or principal stemming from a borrower's failure to repay a loan.

Credit risk has two components:

  • Default probability addresses the likelihood that a borrower will default on its debt obligations, without reference to estimated loss.
  • Loss severity, also known as Loss Given Default (LGD), measures the portion of value an investor loses. If a bond defaults, investors can still expect to recover a certain percentage of the bond; that percentage is called the recovery rate. Loss severity = 1 - recovery rate

Expected loss = Default probability x Loss severity

The spread refers to the difference between the yield on a specific bond and a comparable maturity (or duration) Treasury. The part of the risk premium representing the default risk is known as the credit spread. If the perception of risk increases for the issuer or for the industry category representing the issuer, the spread may increase or widen. This risk associated with an increasing credit spread is known as the credit spread risk. If there are more concerns about economic security, the spread will widen (implying that the premium for risk increases).

Credit risk could be on account of:

  • Downgrade risk: the risk that the issuer will be downgraded, resulting in an increase in the credit spread demanded by the market. The market tends to respond very quickly to news regarding a bond rating decline.

  • Market liquidity risk: the widening of the bid-ask spread on an issuer's bonds. The size and the credit quality of the issuer affects market liquidity risk.

User Contributed Comments 9

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Smarty11: yields DO NOT necessarily decline in anticipation of a downgrade... Spread widening is a funtion of downgrade. Yields, however, are complicated to analyze. They drive up and down based on economic factors - such as inflation.
snider: are you sure?! when we do analysis we should assume other factors being constant. if there is a downgrade ahead surely the yield will decline.
mattl31: price will decline, yield will increase
mysking: isn't yield has been pre-fixed?
siuhunghung: If spread widen, there are more risk then obviously yield has to go up to compensate for the extra risk.
bmeisner: Ok being a corporate bond trader I can clue you guys in on how it actually works. 1. Spreads are always calcuated off LIBOR/IRswaps, not off treasuries, especially in the environment after the credit melt down because even the spread between LIBOR/IRswaps and T-bills has widened significantly because bank credit risk has increased. 2. Ratings downgrades are usually a lagging indicator these days, not leading. The only case when they are relevant is when a corporate goes from an investment grade rating to a specualtive rating (for S&P the lowest investment grade rating is BBB-). The reason why this matters is because a lot of insurance companies and investment funds are only allowed to hold investment grade corporate debt by the funds' original mandate.
thalor: So downgrade risk only matters at the edge of investment-grade versus junk? As in, institutional investors don't do their own credit rating assessments?
Seemorr: At least in municipal bonds, ratings matter a lot, and spreads are almost always calculated versus Treasuries.
johntan1979: From previous modules:

Credit risk includes
1. Default risk
2. Credit spread risk
3. Downgrade risk