Bond credit risk: how to assess it

Anyone who buys a bond is lending money to the issuer. Credit risk is the possibility that the issuer does not pay the coupons or does not repay the capital, in full or in part. It is the main risk of corporate bonds, and the reason why some yield much more than others.

No single number captures it completely. Ratings, spreads and the structure of the bond each show a different side of the same risk, and diversification is what keeps a single problem from becoming a large loss.

Unlike interest rate risk, which affects all bonds of a similar duration in much the same way, credit risk is specific to each issuer. That is what makes it worth studying bond by bond, and what makes spreading your money across issuers so effective.

The first indicator: the rating

Rating agencies summarise credit risk in a letter, from AAA to D. The most important division is between investment grade (down to BBB-) and high yield (from BB+ downwards). The rating is useful but often lags behind events: it should be used as a starting point.

A rating reflects the agency's view at the time of its last review. Between one review and the next, the situation of the issuer can change, and the market usually reacts faster than the agencies.

The second indicator: the spread

The spread is the difference between the bond's yield and that of a security considered almost risk-free with the same maturity, for example a German government bond. A wide spread means the market is asking for more compensation for that issuer's risk. If an issuer's spread rises much more than that of competitors with the same rating, the market is signalling a problem.

Because it moves every day with prices, the spread is the most up-to-date reading of how the market judges an issuer. Comparing it with issuers of similar rating and maturity is what makes it informative.

How much you lose in a default

A default does not necessarily mean losing everything. How much is recovered depends on:

• seniority: senior bonds are repaid before subordinated ones; the latter yield more precisely because they recover less;
• collateral: bonds secured by specific assets (for example covered bonds) recover more;
• the issuer's sector and assets.

For banks in the European Union there is also bail-in: in a crisis, the authorities can impose losses on bondholders, starting with subordinated securities.

This is why two bonds from the same issuer can carry different risks: a senior bond and a subordinated bond of the same bank sit in different places in the queue if things go wrong.

The simplest remedy: diversify

The risk of a single issuer is reduced by spreading capital across several issuers, sectors and countries. This is why 10BONDS lists include only one bond per issuer: ten bonds are ten different issuers.

Diversification does not remove credit risk, but it changes its shape: instead of one default being able to wipe out a large part of the portfolio, each issuer accounts for only a fraction of it.

Yield and risk go together

For the same duration, a higher yield is almost always the price of higher credit risk. When a bond yields much more than others with the same rating, ask yourself why. Compare, for example, investment grade bonds with high yield bonds in the bond finder.

The yield to maturity itself assumes that the issuer pays everything: the higher the credit risk, the less certain that assumption becomes.

Find your 10 bonds: use the rating slider to choose how much credit risk you accept.