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CFA® Level I · Fixed Income · free lesson
Credit Risk
Most of the world's bonds carry the risk that the borrower will not pay in full and on time. This module breaks credit risk into probability of default and loss given default, shows how analysts assess a borrower with the traditional Cs of credit, explains what credit ratings can and cannot tell you, and links credit spreads, their drivers and their changes to the returns that bond investors actually earn.
What you will learn
1. Describe credit risk and its components, and calculate expected loss from the probability of default and the loss given default.
- Credit risk = default risk (probability of default) + loss severity (loss given default).
- LGD = 1 - recovery rate; it depends on seniority, collateral and asset values at default.
- Expected loss = PD x LGD (x exposure for a currency amount).
- Spread ≈ PD x LGD, so PD implied by a spread ≈ spread / LGD (an upper-end estimate).
- Bonds of the same issuer share a PD but can have very different LGDs.
2. Explain the traditional Cs of credit analysis and how capacity, capital, collateral and covenants inform an assessment of a borrower's ability and willingness to pay.
- Capacity: ability to service debt from cash flow; usually the most important C.
- Capital: equity and other resources that absorb losses before creditors.
- Collateral: pledged or available assets; mainly reduces loss given default.
- Covenants: affirmative (must do) and negative (must not do) terms that protect creditors.
- Character (management quality and integrity) and conditions (the environment) are commonly added.
3. Describe the role of credit rating agencies and their rating scales, and explain the uses and limitations of credit ratings.
- Investment grade = Baa3/BBB- or higher; high-yield = Ba1/BB+ or lower.
- Issuer ratings reflect default risk; issue ratings are notched for seniority and collateral.
- A downgrade from investment grade (fallen angel) can trigger forced selling.
- Ratings are stable by design and tend to lag market spreads.
- Ratings may miss event risk and have failed badly (structured finance, 2007-08).
4. Describe the macroeconomic, market and issuer-specific factors that influence the level and volatility of credit spreads.
- Spread = compensation for expected loss + uncertainty of loss + illiquidity.
- Macro: spreads narrow in expansions and widen in recessions (credit cycle).
- High-yield spreads are more cyclical and volatile than investment-grade spreads.
- Market: liquidity, dealer capacity, supply and fund flows; flight to quality in crises.
- Issuer-specific: leverage, profitability, events (M&A, buybacks, scandals), rating actions.
5. Calculate the approximate effect of a change in credit spread on a bond's price and holding-period return using duration and convexity.
- %ΔPV ≈ -(ModDur x ΔSpread) + 0.5 x Convexity x (ΔSpread)^2, holding the benchmark constant.
- Spread duration ≈ modified duration for fixed-rate bonds; for FRNs it is near maturity, not near the reset.
- Excess return ≈ spread x t - spread duration x Δspread (ignoring convexity and default losses).
- Breakeven widening = spread x t / spread duration.
- Long-duration and low-rated bonds carry the most spread risk.
Module at a glance
- Credit risk = probability of default x loss given default; LGD = 1 - recovery rate.
- Expected loss = PD x LGD; bonds of one issuer share a PD but differ in LGD by seniority and collateral.
- The Cs of credit: capacity, capital, collateral, covenants, with character and conditions often added.
- Investment grade ends at Baa3/BBB-; downgrades below it create fallen angels and forced selling.
- Ratings are useful but lag markets, miss event risk and can be badly wrong.
- Spreads compensate for expected loss, uncertainty and illiquidity, and widen most for low-rated bonds in recessions.
- %ΔPV ≈ -ModDur x ΔSpread + 0.5 x Convexity x (ΔSpread)^2; excess return ≈ spread carry - spread duration x Δspread.
This free module has 5 lessons, 14 practice questions with full explanations.