Credit risk is the risk of loss that would occur if an issuer fails to make full and timely payments of interest and principal. It has two components:
- Default risk or default probability, the risk that the issuer will fail in making the required payments on time, and
- Loss severity (also called loss given default), which represents the magnitude of loss given that an issuer has defaulted.
While it is important to look at the distribution of default probabilities and the associated loss severity, it is useful to use a single (average) default probability and calculate expected loss which is the product of default probability and loss given default.\[Expected\ Loss=Default\ Probability × Loss\ Given\ Default \]
Loss given default
Loss given default is expressed either in absolute terms or as a percentage of the principal. It is also expressed as 1 minus the recovery rate, where the recovery rate is the percentage of principal recovered in the event of default.
Spread risk is the risk that the yield spread of a bond would widen resulting in a decrease in the bond’s value. Yield spread represents the basis points by which a bond’s yield exceeds the yield on default-risk free bonds, such as Treasury bonds. Yield could widen either due to (a) a deterioration in creditworthiness, in which case it is also called credit migration risk (or downgrade risk), and (b) increase in liquidity risk, in which case it is called market liquidity risk.
Market liquidity risk
Market liquidity risk represents a risk that an investor might not be able to buy/sell the bond at the price indicated in the market. It arises because unlike stocks, bonds are not traded on an exchange but are traded with dealers in the over-the-counter market and the willingness of traders to make a market in a bond is reflected in their bid-ask spread. A higher bid-ask spread means higher transaction costs.
Issuer-specific factors that affect bid-ask spread include the size of the issuer (and the size of the outstanding bond issue) and the credit quality of the issuer. During financial crises, market liquidity dries up and yield spreads soar.