A bond's price falls when default risk rises, even if the issuer never actually misses a payment. Master the components, then the ratings, then the spread drivers.
Credit risk is the risk that the issuer fails to make scheduled interest or principal payments in full and on time. Two components drive it.
Probability of Default (POD). The likelihood the issuer misses a contractual payment over a given horizon. POD rises with leverage, weak cash flow coverage, and recessionary stress.
Loss Given Default (LGD). The fraction of exposure lost if default occurs, expressed after recovery. If recovery is 40 cents per dollar, LGD = 60%. LGD depends on seniority, collateral, and the bankruptcy regime.
KEY: Two bonds can have identical POD but very different expected losses if seniority differs. A senior secured bond may recover 60 cents, while a subordinated bond on the same issuer recovers 20 cents. The seniority changes LGD, not POD.
Common mistakes
- Equating POD with expected loss. POD is one component; LGD and exposure scale it. Trap: reporting a "3% loss" when POD is 3% and recovery is 35%, ignoring that expected loss is 1.95%, not 3%.
- Treating recovery rate as LGD. LGD = 1 − Recovery. A 40% recovery is a 60% LGD. Trap: multiplying POD by recovery instead of by LGD.
- Assuming same rating means same POD. Ratings reflect expected loss, which blends POD and LGD. A senior secured BBB and a subordinated BBB on different issuers can have very different PODs.
Bottom line
- Expected Loss = POD × LGD × Exposure, where LGD = 1 − Recovery Rate. POD and LGD are estimates, not observables, so equal POD does not mean equal loss.
- Investment grade is BBB−/Baa3 and above; speculative ("high yield" or "junk") is BB+/Ba1 and below.
- The three NRSROs are S&P, Moody's, and Fitch. Ratings are issuer-paid, lag the market, and address credit only (not liquidity or rate risk).
- Yield spread = credit spread + liquidity premium. Macro factors (cycle, policy, inflation), market factors (risk aversion, technicals, liquidity), and issuer factors (leverage, industry, covenants) move spreads.
Exam shortcut
Memorize Expected Loss = POD × LGD × Exposure and always convert recovery into LGD (1 − Recovery) before multiplying. For spread questions, classify each driver as macro, market, or issuer; the question usually rewards isolating the issuer-specific residual. When asked about rating limitations, lead with lag, issuer-pays conflict, and "credit only, not liquidity or rates."
The full lesson (about 1,970 words, 13 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- credit risk
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