Credit Risk

Macroeconomic conditions such as economic growth, interest rates, and the credit cycle influence yield spreads. For example, during economic expansions, credit spreads typically narrow as the perceived credit risk decreases.

Market liquidity, the bid-ask spread, and overall market sentiment towards risk influence yield spreads. For instance, during financial distress, investors might prefer safer assets, causing spreads on riskier bonds to widen.

Factors such as an issuer's financial performance, credit rating changes, and the specifics of the bond issuance (like coupon rate and maturity) directly affect the yield spread of an issuer's bonds.

Changes in yield spreads directly impact bond prices. An increase in spreads leads to a decrease in bond prices and vice versa. This relationship is quantified using bond duration and convexity metrics.

Agencies like Moody's, S&P, and Fitch provide independent assessments of the credit risk associated with bond issuers and their issues, using both quantitative and qualitative analyses.

Symbol-based measures provided by rating agencies that indicate the likelihood of default and potential loss. These ratings range from high-quality (e.g., AAA) to speculative grades (e.g., BB or lower).

Ratings facilitate the comparison of creditworthiness across issuers and industries, influence the pricing of bonds, and are used to meet regulatory and contractual obligations.

Ratings may not promptly reflect market conditions, might overlook certain risks like litigation or environmental issues, and have historically failed in predicting major defaults, leading to financial crises.

Investors are advised to conduct their own analysis rather than solely relying on ratings, as ratings can lag market pricing of credit risk and may not fully capture all relevant financial risks.

POD is the likelihood that an issuer will fail to make full and timely payments of principal and interest. It is typically an annualized measure and reflects the borrower's financial stability and external economic conditions.

LGD represents the investor's loss conditional on an issuer event of default. It combines the severity of loss under a default scenario with the amount of the investor’s claim at the time of default. LGD is calculated as the product of expected exposure and (1 - recovery rate).

RR is the percentage of an outstanding debt claim recovered when an issuer defaults. It affects the LGD as the unrecovered portion of the claim.

EL is the probability-weighted potential loss for a given period, calculated as the product of POD and LGD. It represents the expected economic loss under a potential borrower default over the life of the contract.

Credit spread is the yield difference between a corporate bond and a risk-free government bond, reflecting the compensation investors demand for bearing credit risk. It is approximated by the product of POD and LGD.