Credit Risk in Corporate Bonds

Debt markets play a critical role in the global economy. Companies and governments raise capital in the debt market to fund recurrent expenditures, buy equipment, acquire assets, and so on. As such, bond markets facilitate economic growth.

Credit risk is the risk of loss resulting from a borrower’s failure to make full and timely payments of interest and/or principal. In most instances, the investment will only suffer a partial loss, and bondholders will recover some value. Finance professionals call this the loss-given default (LGD). It is usually expressed as a percentage estimate of the bond position held by the investors.

Credit-related Risks

Spread Risk

Risky debt instruments typically trade at a yield premium or spread to bonds considered “default-risk free,” such as US treasury bonds or German government bonds. Yield spreads in basis points would increase depending on 2 primary factors:

• downgrade risk; and/or
• market liquidity risk.

Credit Migration Risk (or Downgrade Risk)

A decline in an issuer’s creditworthiness often means that a rating agency has downgraded a bond issuer from, let’s say, AA to A. The consequences of this migration are a higher risk of default and widening yield spreads.

Market Liquidity Risk

In a liquid market, selling large amounts of securities quickly will not significantly reduce the price. However, in a relatively illiquid market, such as the corporate bond market, selling many assets quickly will increase the bid-ask spread (not to be confused with the yield spread).

The bid-ask spread is often indicative of market liquidity risk. Therefore, to compensate for the risk of insufficient market liquidity, the yield premium includes a market liquidity component in addition to the credit risk component.

Question

Which of the following best describes a bond’s credit risk?

1. Default probability inherent in fixed-rate instruments.
2. The risk of not getting full interest and principal payments.
3. Expected loss in the event of failure or bankruptcy of a debt issuer.

Solution

The correct answer is B.

Credit risk is the risk of default on a debt that may arise from a borrower’s failure to make required payments.