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Credit risk is the risk of loss to a fixed-income investor arising from the borrower's failure to make timely interest or principal payments (i.e., to service their debt). A borrower that fails to service their debt is said to be in default.

Drivers of credit risk are either borrower-specific (bottom-up) or related to the broader environment (top-down). They are commonly summarized as the Cs of credit analysis.

• Capacity — the borrower's ability to make debt payments on time.
• Capital — other resources available to the borrower that reduce reliance on debt.
• Collateral — value of assets pledged to provide the lender with security in default.
• Covenants — legal terms agreed between borrowers and lenders as part of the bond issue.
• Character — integrity of the borrower (e.g., management quality for a corporate bond) and commitment to honor obligations.

• Conditions — the general economic environment affecting all borrowers.
• Country — geopolitical, legal, and political environment applicable to the debt.
• Currency — FX fluctuations that affect a borrower's ability to service foreign-denominated debt.

Credit risk ultimately stems from the possibility that the borrower's sources of repayment do not generate enough cash to service its debt.

• Secured corporate debt is backed primarily by operating cash flows and investments, plus cash flows from the pledged collateral.
• Unsecured corporate debt relies only on operating cash flows and investments, plus secondary sources such as asset sales, divestitures, or new debt/equity issuance.
• Sovereign debt is backed by tax revenue, tariffs, and government fees; secondary sources include further debt issuance and privatizations.

Corporate credit risk may be driven by weak economic conditions, intensifying competition, low profitability, or excessive leverage. Sovereign credit risk is shaped by economic and political weakness, persistent fiscal deficits, and a high debt-to-GDP ratio.

Analysts must distinguish two states:

• Illiquid — unable to raise enough cash to service debt at a given moment.
• Insolvent — total assets fall below total debt.

An illiquid issuer is not necessarily insolvent, but can still default.

When default occurs, indenture clauses determine how losses are distributed:

• Cross-default — default on one bond issue triggers default on all issues of the same issuer.
• Pari passu — bonds of the same class rank equally in the default process.

When unsecured debt has both pari passu and cross-default provisions, a default on any one issue gives every unsecured holder a claim on the issuer's general assets. For secured debtholders, such clauses give access to both the general assets and the specifically pledged collateral. Secured bondholders only suffer credit losses when the value of pledged assets falls below the amount of pari passu secured debt.

Credit risk is quantified through the expected loss from a debt investment in the event of default:

$$\text{expected loss} = \text{probability of default} \times \text{loss given default}$$

• Probability of default (POD) — the probability that the borrower fails to make interest or principal payments when due, usually expressed as an annualized rate.
• Loss given default (LGD) — the loss the investor suffers if the issuer defaults; can be a monetary amount or a percentage.
• Expected recovery rate — the share of the claim recovered in default.
• Loss severity — one minus the recovery rate (i.e., the share not recovered).
• Expected exposure / exposure at default — the difference between the amount owed (principal plus accrued interest) and the value of available collateral.

Loss given default expressed as a percentage equals expected exposure times loss severity:

$$\text{LGD\%} = \text{expected exposure} \times (1 - \text{recovery rate})$$

The annualized expected loss (in percentage terms) approximates the credit spread an investor should demand over a risk-free benchmark for bearing the issue's credit risk:

$$\text{credit spread} \approx \text{POD} \times \text{LGD\%}$$

• If the actual spread exceeds this estimated spread, investors are more than fairly compensated for credit risk.
• If the actual spread is below the estimate, investors are inadequately compensated and should avoid the bond.

To assess required returns from credit-risky bonds, an analyst must estimate POD for the issuer and LGD for the specific issue.

Probability of default can be assessed via quantitative measures of capacity to repay. A high-credit-quality issuer (low POD) typically shows:

• Strong profitability (high EBIT margin)
• High interest coverage ratio (EBIT / interest)
• Low leverage multiples (e.g., debt / EBITDA)
• High cash flow to net debt

Loss given default depends on whether the bond is secured or unsecured and on its seniority in the capital structure. More senior, secured debt typically has a smaller LGD than junior, unsecured debt.

Investment grade issuers have a lower POD than high-yield issuers due to greater financial strength. However, high-yield bonds are often secured with secondary repayment sources, so high-yield secured debt can have a lower LGD than unsecured investment-grade debt. The dominant risk for unsecured investment-grade investors is therefore not rising LGD but a rising POD as the issuer's financial condition deteriorates.

Credit rating agencies assign forward-looking ratings to both bond issuers and individual bond issues, based on qualitative and quantitative credit risk factors.

Common uses of credit ratings include:

• Comparing credit risk across issuers, industries, and bond types, and tracking changes in credit conditions over time.
• Assessing credit migration risk — the risk that a rating downgrade reduces bond value and may trigger contractual clauses.
• Meeting regulatory, statutory, or contractual requirements (e.g., investment mandates that restrict holdings to investment grade).

Triple A (AAA / Aaa) is the highest rating. Bonds rated Baa3 / BBB− or higher are investment grade; bonds rated Ba1 / BB+ or lower are non-investment grade, also called high-yield or junk bonds. Bonds in default are rated D by S&P and Fitch and fall in Moody's lowest category, C.

Relying on rating agency ratings carries risks:

1. Ratings lag market pricing. Market prices and credit spreads can move much faster than ratings. Two bonds with the same rating may trade at different yields — ratings focus on expected loss, while distressed-debt prices focus more on default timing and expected recoveries.
2. Some risks are hard to assess. Litigation, natural disasters, environmental risks, acquisitions, and debt-funded equity buybacks are difficult to predict and may not be captured in ratings. Different agencies may take different views, producing split ratings.
3. Agencies make mistakes. Subprime mortgage securities famously received ratings far above what they deserved before the 2008–2009 global financial crisis. Corporate fraud has also caused highly rated firms to default suddenly.

Investors should perform their own due diligence and not rely solely on ratings. Investors who trade in anticipation of rating changes will outperform those who trade in reaction to them.

Credit spread risk is the risk that yield spreads widen due to deteriorating conditions, causing prices of credit-risky bonds to fall. For investment-grade investors this is the primary credit concern, since outright default is unlikely to be sudden — the realistic worry is spread widening as conditions worsen. Spread risk arises from macroeconomic, issuer-specific, and market (trading-related) factors.

Credit risk follows the economic cycle: in expansions, POD falls and spreads contract; in recessions, POD rises and spreads widen. Typical patterns:

• Investment-grade issuers have lower yield spreads than high-yield issuers because expected loss is lower.
• Yield spreads usually increase with maturity because POD rises over longer horizons, producing upward-sloping credit spread curves (spread vs. maturity).
  • In contractions, both investment-grade and high-yield curves rise and flatten as near-term default risk increases. The high-yield curve may even invert (slope downward) at this stage.
  • In expansions, both curves fall and steepen as near-term default risk decreases. Curves are at their lowest and steepest near the cycle peak.
• Across issuers, the dispersion of high-yield spreads is wider than that of investment-grade spreads.
• High-yield spreads fluctuate more than investment-grade spreads as conditions change. In crises, high-yield spreads can widen sharply during a flight to quality, and bid-offer spreads on (less liquid) high-yield debt may widen more than on investment-grade debt.

Holding high-yield debt is riskier in spread terms (more volatile spreads) but offers higher yield. Other reasons investors take this exposure:

• Diversification — high-yield prices have low or negative correlation with investment-grade prices, diversifying a fixed-income portfolio.
• Capital appreciation — larger spread tightening during recoveries produces larger price gains than for investment-grade.
• Equity-like returns — empirical data suggests high-yield offers equity-like returns with lower volatility than equities.

Other systematic forces that can push yield spreads higher:

• Tighter regulation of broker-dealers and corporate bond market makers raises the cost of funding bond positions.
• Funding stresses across markets can heighten risk aversion.
• Heavy new bond issuance may not be matched by investor demand.

The financial performance of the issuer materially affects the level and volatility of its bond spreads. Investors compare an issuer's spread to the average for its rating cohort: an issuer with debt-service problems will trade wider than the average for its rating.

Market liquidity risk reflects the cost of trading a bond, often assessed via the dealer's bid-offer spread. A wider bid-offer spread means higher trading costs and higher liquidity risk.

• Issuers with more debt outstanding or higher credit ratings tend to have more actively traded bonds (narrower bid-offer spreads, lower liquidity risk).
• Liquidity risk is higher for less actively traded bonds, lower-quality issuers, and issuers with little debt outstanding.
• Bid-offer spreads can widen sharply for high-yield issuers during financial stress; rising risk aversion may then spill over to investment-grade names too.

Dealer bid-offer spreads can be used to isolate the liquidity component of yield spread: compute the yield at the bid price and at the offer price; the difference is treated as the liquidity spread, and the remaining spread is attributed to credit risk.

The price impact of a change in spread can be estimated using the bond's duration and convexity, replacing the yield change with the spread change:

$$\Delta(\text{full price}) \approx -\text{ModDur} \cdot \Delta\text{Spread} + \tfrac{1}{2}\,\text{convexity}\,(\Delta\text{Spread})^2$$