Credit Risks

Fundamentals of Credit Analysis | CFA Level I Fixed Income

Credit Risks and Credit-Related Risks

Welcome back to our last topic for this Fixed Income course. We’re about to dive into the basic principles of credit analysis, mainly focusing on corporate bonds. In this lesson, we’ll explore the key components of credit risk and credit-related risks. So, let’s get started!

Credit Risk: Default Risk and Loss Severity

Credit risk is the risk of losses incurred by a lender due to the borrower’s failure to make timely and full payments of interest or principal. Credit risk has two main components: default risk and loss severity.

Default risk is the probability that a borrower fails to pay interest or repay principal when due. A default can lead to losses of various magnitudes, but in most cases, lenders may recover some value, preventing a total loss on the investment.

Loss severity is an estimate of the value the lender may lose if the borrower defaults. It can be expressed as a monetary amount or as a percentage of a bond’s value.

The expected loss is equal to the loss severity multiplied by the default risk. It can be stated as a monetary value or as a percentage of a bond’s value.

Expected Loss = Loss Severity x Default risk

The recovery rate is the percentage of a bond’s value an investor will receive if the issuer defaults. Recovery rate is equal to one minus the loss severity in percentage terms.

Recovery Rate = 1 – Loss Severity

EXAMPLE

If the probability of default is 1% and the loss severity in the event of a default is 30%, the expected loss to the lenders is 0.3% of the bond’s value. The recovery rate of the bond is 70%.

Credit Yields and Spreads

Bonds with credit risk trade at higher yields than risk-free bonds. The difference in yield between a credit-risky bond and a credit-risk-free bond of similar maturity is called its yield spread. For instance, if a 2-year corporate bond is trading at a yield of 6% and the current yield on 2-year treasury notes is 2.5%, the spread is +350 bp.

Bond prices are inversely related to spreads. A wider spread implies a lower bond price, and a narrower spread implies a higher price.

The size of the spread reflects the creditworthiness of the issuer and the liquidity of the market for its bonds.

Credit Migration Risk, Market Liquidity Risk, and Spread Risk

Credit migration risk or downgrade risk is the possibility that spreads will increase because the issuer has become less creditworthy. Credit rating agencies assign ratings to bonds and issuers, and may upgrade or downgrade these ratings over time. A credit downgrade will usually cause the yield spread to widen.

Market liquidity risk is the risk of receiving less than market value when selling a bond due to wider bid-ask spreads. When liquidity is tight, the yield spread increases. Market liquidity risk is greater for bonds of less creditworthy issuers, and the bonds of smaller issuers with relatively little publicly traded debt also have higher market liquidity risk.

Spread risk is the possibility that a bond’s spread will widen due to one or both of these factors: credit migration risk and market liquidity risk.

And that wraps up this lesson, where we’ve learned about credit risks and credit-related risks in the context of credit analysis for corporate bonds. Now you have a solid foundation to understand the components of credit risk and how they affect bond prices and yields. In the following lessons, we’ll dive deeper into capital structure, seniority rankings, credit ratings, and more. Stay tuned!

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