Corporate Bonds: Credit Ratings, Spreads and Default Risk
Read credit ratings, split a credit spread into expected loss and risk premium, and understand seniority and covenants.
What you will learn
- How the rating scales of S&P, Moody's and Fitch map to each other, and where investment grade ends.
- What a credit spread is and how to split it into expected loss and other compensation.
- How seniority, security and covenants change what you recover in a default.
- How to calculate a break-even default rate for a corporate bond.
Explanation
Debt ratios and interest coverage were covered in the stocks course (lesson "Financial health"). Here we look at debt from the lender's side.
Credit ratings
A credit rating is a rating agency's opinion of an issuer's ability and willingness to pay its debt on time. The three large agencies use these scales:
| S&P / Fitch | Moody's | Category |
|---|---|---|
| AAA | Aaa | Highest quality |
| AA+ to AA− | Aa1 to Aa3 | Very high quality |
| A+ to A− | A1 to A3 | High quality |
| BBB+ to BBB− | Baa1 to Baa3 | Lowest investment grade |
| BB+ and below | Ba1 and below | High yield ("speculative grade") |
The line between BBB− (Baa3) and BB+ (Ba1) is important: many funds and institutions may hold only investment-grade bonds. Agencies also publish an outlook (positive, stable, negative) and can place a rating "on watch" before a possible change. Ratings are opinions, not guarantees; they can lag market prices, and the agencies are paid by the issuers they rate.
The credit spread
The credit spread is the corporate bond's yield minus the yield of a government bond (or of an interest-rate swap, a benchmark rate used by banks) with the same maturity. It compensates for:
- Expected loss = probability of default (PD) × loss given default (LGD). LGD = 1 − recovery rate, the share of face value you do not get back.
- Risk premium: payment for uncertainty, because defaults cluster in recessions, exactly when investors can least afford losses.
- Liquidity premium: many corporate bonds trade rarely, with wide bid–ask spreads, especially in small sizes on exchanges.
The spread you see is therefore usually larger than the expected loss. That gap is not "free money"; it is payment for bearing risk that may show up all at once.
Seniority, security and covenants
- Senior secured bonds are backed by specific assets (collateral) and are repaid first.
- Senior unsecured bonds rank next, together with other general creditors.
- Subordinated bonds are repaid only after senior debt. Bank subordinated bonds can also be written down by regulators before insolvency.
- Covenants are promises in the bond terms, such as limits on extra debt or asset sales. Fewer covenants mean less protection.
Two bonds of the same company can therefore carry different ratings and spreads.
Callable bonds
Many corporate bonds are callable: the issuer may repay early at a set price. For these, check the yield to worst, the lowest of the yield to maturity and the yields to each call date.
Worked example
Hypothetical example: a 5-year senior unsecured bond of a BBB-rated company yields 4.6%. The 5-year Bund yields 2.4%. You assume an annual default probability of 1% and a recovery rate of 40%. Fees, bid–ask spreads and taxes are excluded.
- Credit spread = 4.6% − 2.4% = 2.2 points = 220 bp.
- LGD = 1 − 0.40 = 0.60.
- Expected loss per year = 1% × 0.60 = 0.60% (60 bp).
- Remaining compensation = 220 − 60 = 160 bp for risk and liquidity.
- Break-even annual default rate = spread ÷ LGD = 2.2% ÷ 0.60 ≈ 3.67%. Above this, you would on average earn less than on the Bund.
If the company defaults, a €1,000 bond with 40% recovery returns about €400, and the coupons stop.
Common mistake
Practice activity
On paper, with hypothetical data: a 5-year subordinated bond yields 5.4%, the 5-year Bund yields 2.5%. You assume an annual default probability of 0.5% and a recovery rate of 40%. (a) Calculate the spread. (b) Calculate the expected loss per year and the remaining compensation. (c) Calculate the break-even annual default rate. (d) Explain why a recovery rate of 40% may be too optimistic for this bond.
Show solution
(a) 5.4% − 2.5% = 290 bp.
(b) Expected loss = 0.5% × 0.60 = 0.30% (30 bp). Remaining compensation = 290 − 30 = 260 bp.
(c) 2.9% ÷ 0.60 ≈ 4.83% per year.
(d) Subordinated creditors are repaid only after senior creditors, so recoveries are usually lower; with a lower recovery, the LGD rises and the break-even default rate falls.
Limitations: this simple model assumes a constant default rate and recovery, and ignores the timing of defaults and price changes before maturity.
Key takeaways
- Investment grade ends at BBB− (S&P/Fitch) or Baa3 (Moody's); below that is high yield.
- Credit spread = expected loss (PD × LGD) + risk premium + liquidity premium.
- Seniority, collateral and covenants decide how much you recover after a default.
- For callable bonds, judge the yield to worst, not only the yield to maturity.
Next step
In the next lesson you will look at bonds below investment grade and see how their prices move through the credit cycle.
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