Debt markets play a critical role in the global economy. Companies and governments raise capital in the debt market to fund current operations, 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 (debt issuer) failure to make full and timely payments of interest and/or principal. In most instances, there will be only a partial loss on the investment, 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.
Risky debt instruments typically trade at a yield premium, or spread, to bonds that are considered “default-risk free”, such as US treasury bonds or German government bonds. Yield spreads in basis points would increase 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. This migration results in a higher risk of default, and widening yield spreads.
Market Liquidity Risk
In a liquid market, selling large amounts of securities quickly will not reduce the price much. In a relatively illiquid market, such as the corporate bond market, selling many assets quickly will result in an increase in the bid-ask spread (not to be confused with the yield spread).
The bid-ask spread if often indicative of market liquidity risk. To compensate for the risk of insufficient market liquidity, the yield premium includes a market liquidity component in addition to the credit risk component.
Which of the following best describes a bond’s credit risk?
A. Default probability inherent in fixed-rate instruments
B. Expected loss in the event of failure or bankruptcy of a debt issuer
C. The risk of not getting full interest and principal payments
The correct answer is C.
Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments.
Reading 55 LOS 55a:
Describe credit risk and credit-related risks affecting corporate bonds