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Credit risk /Default risk and bond rating

The credit risk or default risk is the risk of an issuer not making timely interest or principal payments as promised. Bonds issued by the US federal government have nearly zero default risk while corporations have risk of being unable to meet payments (and default on their debts). Since the standard investor is risk-averse, the issuer of a lower-rated bond must promise a higher yield in return to the additional default risk taken by the investors.  The difference between the yield on a Treasury security, which is considered as a default-free bond, and the yield of a bond with similar features but lower bond rating is called credit spread.

Yield on a risky bond = yield on a default-free bond + credit spread

A Bond rating is the common indicator of the probability of default. Rating agencies rate the bonds using their own rating systems on an ongoing basis and issue alert when there is a change in a company’s bond rating. Lower-rated bonds have more default risk, and vice versa. A bond with AA rating is less likely to default than an A rated bond, which is less likely to default than a bond with BBB (triple B) rating, and so on. The bond rating grades of the 3 major rating agencies are summarized as below table.

Credit Risk

Moody’s

Standard and Poor’s

Fitch

Investment Grade

Highest Quality

Aaa

AAA

AAA

High Quality

Aa

AA

AA

Upper Medium

A

A

A

Medium

Baa

BBB

BBB

Not Investment Grade

Lower Medium

Ba

BB

BB

Lower Grade

B

B

B

Poor Grade

Caa

CCC

CCC

Speculative

Ca

CC

CC

No Payments / Bankruptcy

C

D

C

In Default

C

D

D

Note that the bond rating indicates relative risk of default, not absolute risk. Moreover, when a rating agency fails to provide independent rating assessment (mostly because the issuers pay the rating agencies to rate their bonds), especially when fraud is involved, the rating can be completely wrong.