Credit Risk in Corporate Bonds

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.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.