credit risks affecting corporate bonds

Credit risk is the risk associated with losses stemming from the failure of a borrower to make timely and full payments of interest or principal. Credit risk has two components: default risk and loss severity.

• Default risk is the probability that a borrower (bond issuer) fails to pay interest or repay principal when due.
• Loss severity, or loss given default, refers to the value a bond investor will lose if the issuer defaults. Loss severity can be stated as a monetary amount or as a percentage of a bond’s value (principal and unpaid interest).

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

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

Bonds with credit risk trade at higher yields than bonds thought to be free of credit risk. The difference in yield between a credit-risky bond and a credit-risk-free bond of similar maturity is called its yield spread. For example, if a 5-year corporate bond is trading at a spread of +250 basis points to Treasuries and the yield on 5-year Treasury notes is 4.0%, the yield on the corporate bond is 4.0% + 2.5% = 6.5%.

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 ofthe issuer and the liquidity of the market for its bonds. Spread risk is the possibility that a bond’s spread will widen due to one or both of these factors.

• Credit migration risk or downgrade risk is the possibility that spreads will increase because the issuer has become less creditworthy. As we will see later in this reading, credit rating agencies assign ratings to bonds and issuers, and may upgrade or downgrade these ratings over time.
• Market liquidity risk is the risk of receiving less than market value when selling a bond and is reflected in the size of the bid-ask spreads. Market liquidity risk is greater for the bonds of less creditworthy issuers and for the bonds of smaller issuers with relatively little publicly traded debt.