Page 30 - FINAL CFA SLIDES DECEMBER 2018 DAY 15

LOS 55.a: Describe credit risk and credit-related
risks affecting corporate bonds. Session Unit 16:
LOS 55.b: Describe default probability and loss 55. Fundamentals of Credit Analysis
severity as components of credit risk., p.127

Credit risk - losses from counter party’s failure to effect timely and full payments of interest or

principal:
• Default risk - probability that a borrower (bond issuer) fails to pay interest or principal when due.
• Loss severity –(Expected Loss) the value a bond investor will lose if the issuer defaults; stated in

monetary amount or as a % of a bond’s value (principal and unpaid interest).

The recovery rate is the % of a bond’s value an investor will receive if the issuer defaults. Loss severity
tanties
as a percentage is equal to one minus the recovery rate.

Yield Spread - difference in yield between a credit-risky bond and a credit-risk-free bond of similar

maturity (spread is risk, hence bond prices are inversely related to spreads; a wider spread implies a
lower bond price and a narrower spread implies a higher price)

Spread risk is the possibility that a bond’s spread will widen due to one or both of these factors.
• Credit migration or downgrade risk is the possibility that spreads will increase because the issuer

has become less creditworthy.
• Market liquidity risk is the risk of receiving less than market value when selling a bond and is
reflected in the size of the bid-ask spreads; it is greater for the bonds of less creditworthy issuers

and for the bonds of smaller issuers with relatively little publicly traded debt.