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Credit Analysis and Spreads: The Price of Risk
Chapter 4. Credit Analysis and Spreads: The Price of Risk
Not all bonds are created equal. While government bonds (Treasuries) are often considered “Risk-Free,” corporate bonds carry ==Credit Risk==—the possibility that the company might not pay back its debt. To compensate for this risk, corporate bonds must pay a higher interest rate than Treasuries. This difference is known as the “Spread.”
1. The Language of Credit: Ratings
Credit rating agencies act as the “Judges” of the bond world. They assign grades based on a company’s financial health.
Global Credit Rating Scale
| Category | S&P / Fitch | Moody's | Description |
|---|---|---|---|
| **Investment Grade** | AAA to BBB- | Aaa to Baa3 | Highest quality; low default risk. Suitable for conservative funds. |
| **Speculative (Junk)** | BB+ to B- | Ba1 to B3 | High Yield; significant risk but higher potential returns. |
| **Distressed / Default** | CCC to D | Caa to C | Extremely high risk; often already in default or restructuring. |
2. The Credit Analysis Workflow (The 5 Cs)
How do institutional analysts decide if a bond is worth buying? They follow a systematic “Credit Check.”
Evaluating the management's integrity and track record
Analyzing cash flow and the ability to service debt (Interest Coverage Ratio)
Checking the company's leverage and 'Skin in the Game'
Identifying specific assets that can be seized in case of default
Assessing how the industry and economy impact the borrower
3. Mastering the Spreads
Spreads are the most important numbers for corporate bond traders. They tell you exactly how much “Risk Premium” you are being paid.
- Option-Adjusted Spread (OAS): The spread after removing the value of embedded options. This is the “Purest” measure of credit risk.
- TED Spread: The difference between the 3-month LIBOR and the 3-month Treasury bill. It is a classic indicator of ==Systemic Risk== and fear in the banking system.
- Credit Spread Widening: When spreads get larger, it means the market is becoming more fearful of defaults.
The Default Trap: High Yield (Junk) bonds offer attractive double-digit returns, but a single default can wipe out the interest gains of an entire portfolio. Diversification is non-negotiable in credit investing.
4. Conclusion: Pricing the Uncertainty
Credit analysis is the bridge between ==Finance and Reality.== By learning to read ratings and spreads, you gain the ability to spot when the market is being too pessimistic (cheap bonds) or dangerously optimistic (expensive credit).
📚 Prof. Sean’s Selected Library
- [Standard & Poor’s Guide to Credit Analysis]: A deep dive into the methodology used by the world’s leading rating agency.
- [High Yield Bonds] - Theodore Barnhill: Understanding the dynamics of the junk bond market.
- [Corporate Credit Analysis]: Practical tools for analyzing financial statements from a lender’s perspective.
Next time, we will explore ‘Specialized Bonds and Structured Products’—learning about the exotic world of Convertible Bonds and Hybrid Securities.