By the FinLingo Team | Capital markets practitioner, front office experience at a major European investment bank. FinLingo covers 342 lessons from bonds to exotic derivatives. About · Last updated:
Credit risk is the risk that a borrower fails to meet their financial obligations — misses a coupon payment, delays repayment, or defaults entirely. It is the most fundamental risk in lending and bond investing. Every basis point of spread above the risk-free rate is compensation for bearing credit risk.
Rating agencies (S&P, Moody's, Fitch) assign letter grades reflecting creditworthiness. Investment grade runs from AAA (highest quality) to BBB-. High yield (junk) runs from BB+ to D (default). A BBB-rated company has a historical 5-year cumulative default rate of roughly 2%. A B-rated company: roughly 25%. The rating determines the issuer's borrowing cost — each notch lower adds 20–50 basis points to the spread.
The credit spread is the yield difference between a corporate bond and a government bond of the same maturity. A BBB bond yielding 5.5% when the equivalent Treasury yields 4.0% has a credit spread of 150 basis points. This spread compensates for expected default losses, illiquidity, and risk aversion. Spreads widen in recessions (higher perceived risk) and tighten in expansions.
Three quantities are linked: Spread = Probability of Default (PD) × Loss Given Default (LGD). LGD = 1 − Recovery Rate. If a BBB bond has a 150bp spread and the expected recovery rate is 40%, the implied annual default probability is: 150bp / (1 − 0.40) = 150 / 0.60 = 250bp = 2.5%. This is a simplification, but the credit triangle is the fastest way to convert between spreads, default probabilities, and recovery assumptions.
When a company defaults, bondholders typically recover some fraction of face value. Senior secured debt recovers roughly 65%. Senior unsecured: roughly 40%. Subordinated: roughly 25%. Recovery rates vary by industry, economic cycle, and the specific bankruptcy process. They are critical for pricing credit derivatives like CDS and CLNs.
Credit risk is the chance that a borrower does not repay what they owe. When you buy a corporate bond, you face credit risk because the company might default on its coupon or principal payments. The credit spread you earn above the risk-free rate is your compensation for taking this risk.
A credit spread is the difference in yield between a corporate bond and a risk-free government bond of the same maturity. It reflects the market price of credit risk for that issuer. Wider spreads mean higher perceived risk. A BBB bond at 150bp spread over Treasuries means investors require 1.5% extra annual return for bearing the credit risk of that company.
The credit triangle links three quantities: spread, probability of default (PD), and loss given default (LGD). The formula is Spread = PD times LGD. If a bond has a 200bp spread and expected recovery is 40% (LGD = 60%), the implied annual PD is 200bp divided by 60% = 3.33%. It is a simplified model but widely used for quick credit analysis.
FinLingo covers credit markets in Level 1 (5 units) and credit derivatives in Level 6 (10 units). Level 1 is free.
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