Credit Risk and Credit Spreads
A company might not pay you back. The higher the risk, the higher the yield investors demand, and that extra is the credit spread.
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Text version · Bonds & Fixed Income, lesson 5: “Credit Risk and Credit Spreads”
A company might not pay you back. The higher the risk, the higher the yield investors demand, and that extra is the credit spread.
The higher the risk, the more compensation required
The lower the credit rating, the bigger the credit risk, and the more extra return investors demand. Below BBB is high-yield (junk) territory.
Yield = Treasury + credit spread
Treasuries are treated as having no default risk, so the extra yield corporate bonds pay over them is the credit spread.
Default ≠ losing everything
When a bankrupt company is liquidated, bondholders usually still get some money back; that share is the recovery rate. Expected loss ≈ default probability × (1 − recovery rate), and the credit spread has to at least cover it.
Key takeaways
- Credit risk: the issuer can't pay interest or principal on time (default).
- Credit ratings (AAA → BBB is investment grade, BB and below is high yield / junk) reflect how likely a default is.
- Credit spread = corporate bond yield − Treasury yield of the same maturity. A downgrade → wider spread → lower price.
- Default doesn't always mean losing everything: expected loss ≈ default probability × (1 − recovery rate).
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Click “Example: Treasury 4% vs corporate 7%”: what's the credit spread? Which rating does it match?
- Starting from A, keep clicking “Downgrade one notch” and watch the “Corporate bond price”: how much does it fall each notch? Is the drop from BBB to BB (falling out of investment grade) bigger?
- Keep the rating the same and drag the Treasury yield from 4% to 6%: did the spread change? What about the corporate bond price?
- Compare the illustrative default grids for BBB and BB: just one notch apart, how different is the risk?
Quiz and explanations
- 1. The Treasury yield is 4% and a corporate bond yields 7%. What's the credit spread?
- Answer: 3%.7% − 4% = 3%.
- 2. A company's credit rating is downgraded. Its bond price usually…
- Answer: Falls.Risk goes up, investors demand a higher yield, and the price falls.
- 3. A corporate bond has about a 2% chance of default within a year, and after a default you expect to recover 40% of face value. Roughly what's the expected loss over a year, as a share of face value?
- Answer: 1.2%.2% × (1 − 40%) = 1.2%. The credit spread must at least make up for this expected loss.
Terms in this lesson
- credit rating (Credit Rating): A rating agency's grade for how likely a default is, such as AAA, BBB or BB (high yield).
- credit risk (Credit Risk): The risk that the issuer can't pay interest or repay principal on time (defaults).
- credit spread (Credit Spread): How much more a corporate bond yields than a government bond of the same maturity, as compensation for default risk.
- recovery rate (Recovery Rate): The share of face value creditors eventually get back after a default; expected loss ≈ default probability × (1 − recovery rate).