The investors in a bond issue also face credit risk as they are actually lending money to the issuer. The credit risk can arise in three forms, namely, default risk, credit spread risk, and downgrade risk. Let’s look at each of them in detail.
This is the simplest form of credit risk and is the risk that the issuer will be unable to meet its payment obligations or keep up with the terms of payments. Such an event is called a default. Since each issuer is different we don’t have a direct measure of the possibility of default. However, in various studies, people have looked at thousands of bond issues and measured the probabilities of default of these issues. This probability of default is called default rate. Default rate is used as a proxy while measuring the default risk in an issue. When a default occurs the investor does not lose all its money. It will typically recover some money with is referred to as the recovery rate. Using the default rate and recovery rate we can estimate the loss given default in a bond issue.
Credit Spread Risk
Apart from default risk, there is also the risk that the price of the bond will decline due to increase in the yield from the bond. Let’s try to understand how this happens. The yield of a non-treasury bond is made up of two components: The interest rate on a risk-free security, plus a risk premium for the risk associated with the bond.
The risk premium acts as the compensation for all risks associated with the bond issue, and one of its components is the credit spread which is for default risk. If the default risk of a bond issue increases, its credit spread will increase (widen), in turn increasing the expected yield of the bond. This will lead to a fall in the price of the bond.
Since the credit spread of a bond issue increases based on the increase in default risk, how does one measure the changes in default risk or the credit quality of a bond? This is generally done using credit ratings. Credit rating agencies such as Moody’s Standard & Poor’s, and Fitch Ratings, assess the default risk of every debt issue and assign a credit rating to it, which reflects the credit quality of the issue. For example, a bond issue rated AAA reflects high credit quality (low credit risk) compared to another issue rated CCC which reflects poor credit quality (high credit risk). The symbol D represents default. Once an initial rating is assigned the rating agencies continuously monitors the issue and its credit quality. Depending on the change in circumstances, the rating agency may upgrade or downgrade the rating of the debt issue. For example, a debt issue rating AAA may be downgraded to AA on account of poor financial performance of the firm. A downgrade will widen the credit spread leading to a decrease in bond price. This is called downgrade risk.
The portfolio managers also using rating transition matrix to measure downgrade risk.