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Financial Instruments, Markets and Conventions / Credit: Corporate Bonds, Credit Spreads, and the Default Option

Credit-Sensitive Bonds: Corporate Debt, Ratings, and Credit Spreads

In the government bond market, the US Treasury's full faith and credit guarantee means that default risk is effectively zero. Corporate bonds add one more dimension to the analysis: the possibility that the issuer fails to make a scheduled coupon or principal payment. That possibility — default risk — forces investors to demand a yield premium above the risk-free rate. The magnitude of this premium, the credit spread, is the market's price for bearing default risk.

Understanding credit spreads requires understanding three things: the structure of corporate debt (indentures, covenants, seniority); the credit rating system that grades default risk; and the market dynamics that cause spreads to widen during economic downturns and compress during expansions. These institutional building blocks are the foundation for the quantitative credit modelling introduced in the next lesson.

Learning objectives. By the end of this note you should be able to:
  • describe the key provisions of a corporate bond indenture: covenants, call and refunding provisions, and sinking fund requirements;
  • explain the capital structure hierarchy and how seniority determines recovery in default;
  • map credit ratings from Moody's, S&P, and Fitch to their investment-grade vs. high-yield classification;
  • describe the rating lifecycle: issuance, monitoring, credit watch, downgrade, and default;
  • define the credit spread as the yield premium over the matched-maturity Treasury yield and explain why it differs from zero even for investment-grade issuers;
  • interpret the rating transition matrix as a probability statement about credit migration;
  • describe how credit spreads behave across the economic cycle and identify the drivers of spread widening during crises.

In this lesson

  1. Corporate bond anatomy
  2. Capital structure and seniority
  3. Call provisions and embedded optionality
  4. Credit ratings
  5. The credit rating lifecycle
  6. The credit spread

Before you start

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