Learning Module 14
Credit Risk
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe credit risk and its components — probability of default (POD) and loss given default (LGD), and their product (expected loss). Understand the sources of credit risk for different borrower types.
Describe the uses of ratings from credit rating agencies and their limitations — investment grade vs. high yield, rating agency processes, and pitfalls of relying solely on credit ratings.
Describe macroeconomic, market, and issuer-specific factors that influence the level and volatility of yield spreads — credit cycles, market liquidity, leverage, coverage, and the price impact of spread changes.
1 · Credit Risk and Its Components
Credit risk: The risk of economic loss resulting from a borrower's failure to make full and timely payments of interest and principal.
Probability of default (POD): The likelihood that an issuer fails to make full and timely payments. Typically measured annually.
Loss given default (LGD): The investor's loss conditional on an event of default.
LGD = EE × (1 − RR), where EE = expected exposure, RR = recovery rate.Expected loss (EL):
EL = POD × LGD. The probability‑weighted shortfall that investors expect.Credit spread approximation:
Credit Spread ≈ POD × LGD
EL = POD × LGD
LGD = EE × (1 − RR)
Credit Spread ≈ POD × LGD
Sources of Credit Risk
Credit risk: The risk of economic loss resulting from a borrower's failure to make full and timely payments of interest and principal.
Probability of default (POD): The likelihood that an issuer fails to make full and timely payments. Typically measured annually.
Loss given default (LGD): The investor's loss conditional on an event of default.
LGD = EE × (1 − RR), where EE = expected exposure, RR = recovery rate.Expected loss (EL):
EL = POD × LGD. The probability‑weighted shortfall that investors expect.Credit spread approximation:
Credit Spread ≈ POD × LGD
• Profitability (EBIT margin)
• Coverage (EBIT/interest expense)
• Leverage (Debt/EBITDA, Debt/Capital)
• Cash flow stability
• Seniority ranking (secured vs. unsecured)
• Collateral quality
• Recovery rates (industry, cycle)
• Legal/regulatory environment
2 · Credit Rating Agencies and Credit Ratings
Credit Rating Scale (S&P / Moody's / Fitch)
Uses and Limitations of Credit Ratings
Uses: Compare creditworthiness within and across industries; trigger covenants and debt pricing; satisfy regulatory, statutory, and contractual requirements.
Limitations: Ratings may lag market pricing of credit risk; some risks are difficult to capture (litigation, environmental, debt‑financed acquisitions); miscalculations or unforeseen changes may not be captured.
Split ratings: Different agencies may assign different ratings to the same issuer (e.g., WeWork: BB− by Fitch, B+ by S&P, Caa1 by Moody's).
Rating outlooks: Indicate possible future upgrades/downgrades but may still lag market conditions.
3 · Factors Impacting Yield Spreads
Macroeconomic Factors
Credit cycle: Spreads narrow at the top of the credit cycle (low perceived risk) and widen at the bottom (high perceived risk).
Flight to quality: During market stress, investors sell risky assets and buy government bonds, causing credit spreads to widen.
High‑yield bonds: Offer portfolio diversification, capital appreciation potential, and equity‑like returns with lower volatility.
Market Factors
Market liquidity risk: The transaction costs associated with selling a bond. Reflected in bid‑offer spreads.
Issuer size and credit quality: Larger issuers and higher credit quality → more liquid bonds → tighter spreads.
Supply and demand: Heavy new issue supply can widen spreads; high demand tightens spreads.
Issuer-Specific Factors
Debt coverage: Sufficiency of cash flows to make interest and principal payments. Measured by interest coverage ratios.
Leverage: Relative reliance on debt financing. Higher leverage → higher credit risk → wider spreads.
Credit migration risk: Risk that an issuer's creditworthiness deteriorates, causing spreads to widen and prices to fall.
Price Impact of Spread Changes
Duration and convexity: The same duration and convexity statistics that apply for yield changes also apply for spread changes.
Price impact:
%ΔPV ≈ −AnnModDur × ΔSpread + ½ × AnnConvexity × (ΔSpread)²Longer‑duration bonds have higher spread sensitivity — their prices are more volatile with respect to spread changes.
%ΔPV ≈ −AnnModDur × ΔSpread + ½ × AnnConvexity × (ΔSpread)²
4 · Quick Reference — Credit Risk Summary
Concept | Formula / Description |
|---|---|
Expected Loss |
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Loss Given Default |
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Credit Spread |
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Investment Grade | BBB− / Baa3 and above |
High Yield | BB+ / Ba1 and below |
Key IG Ratios | Higher profitability, higher coverage, lower leverage |
Spread Change Impact |
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