Duration is the risk that interest rates move. Credit risk is the risk that the borrower does not pay you back in full. This module shows how to read a credit rating, what the extra yield on riskier bonds is really paying you for, and why credit risk tends to show up at the worst possible moment.
Before most bonds are sold, a credit rating agency grades how likely the borrower is to pay on time and in full. The big three worldwide are S&P Global, Moody’s and Fitch. In Canada, DBRS Morningstar is also widely used. Their scales look slightly different but line up closely.
| S&P / Fitch | Moody’s | Meaning | Typical borrowers |
|---|---|---|---|
| AAA | Aaa | Highest quality | A few national governments, very few companies |
| AA | Aa | Very strong | Strong governments and provinces, a few large companies |
| A | A | Strong | Many provinces, large banks, utilities |
| BBB | Baa | Adequate, the lowest investment grade | Many large companies: pipelines, telecoms, retailers |
| BB | Ba | Speculative | Smaller or more indebted companies |
| B and below | B and below | Highly speculative to near default | Heavily indebted or struggling companies |
Each band is split further with plus and minus signs (or 1, 2, 3 at Moody’s), so BBB+ is better than BBB−. The line that matters most sits between BBB− and BB+. Everything from AAA down to BBB− (Baa3 at Moody’s) is investment grade. Everything below is high yield, also called “junk”.
That line has real consequences. Many pension funds, insurers and bond funds are only allowed to hold investment-grade bonds. When a company is downgraded from BBB− to BB+, it becomes a fallen angel, and those holders may have to sell at the same time, pushing its price down sharply.
Module 1 said that riskier borrowers have to pay more. The extra is the credit spread: how much more a bond yields than a government bond that matures at about the same time.
Spreads are usually quoted in basis points. One basis point is one hundredth of a percentage point, so 100 basis points = 1%.
Example. A five-year BBB-rated corporate bond yields 4.5%. A five-year Government of Canada bond yields 3.0%. The spread is 4.5% − 3.0% = 1.5 percentage points, or 150 basis points.
A spread is the market’s live price for a borrower’s risk. When the spread on a company’s bonds jumps while government yields stand still, the market has started to worry about that company, often before any rating agency acts.
A default is when a borrower misses a payment or breaks the terms of the loan. It does not usually mean you lose everything. Bondholders have a claim on the company’s assets and often recover part of their money, sometimes after a long restructuring. The share you get back is the recovery rate.
That gives a simple way to estimate how much defaults cost a portfolio of bonds each year:
Example. In a portfolio of high-yield bonds, 2% of the borrowers default in a typical year, and bondholders recover 40% of what they were owed. The expected loss is 2% × (1 − 0.40) = 1.2% a year.
If those bonds yield 4 points more than government bonds, about 1.2 points go to covering defaults, leaving roughly 2.8 points of extra return. That is the real reward for taking the risk, before you count what happens in a bad year.
| Investment grade | High yield | |
|---|---|---|
| Yearly default rate, long-run average | Very low, well under 1% | A few percent |
| In a severe recession | Still low | Can reach 10% or more, as in 2009 |
Averages hide the timing. High-yield defaults cluster in recessions, which is exactly when your stocks are falling too.
Credit spreads move with the economy. When times are good, investors are relaxed about lending and spreads are narrow. When a recession looks likely, they demand much more to lend to companies, and spreads widen fast. In late 2008, spreads on US high-yield bonds briefly topped 15 percentage points.
A wider spread means a higher yield on the bond, and a higher yield means a lower price. Duration from Module 3 tells you how much:
Example. In a recession scare, government bond yields fall by 1 point as investors rush to safety, while BBB corporate spreads widen by 2 points. Both bonds have a duration of 5.
| Bond | Change in its yield | Price change (duration 5) |
|---|---|---|
| Government bond | −1 point | about +5% |
| BBB corporate bond | −1 + 2 = +1 point | about −5% |
| High-yield bond, spread widens 6 points | −1 + 6 = +5 points | about −25% |
This is why high-quality government bonds are the better shock absorber. When stocks crash, they often rise. Corporate bonds, and especially high-yield bonds, tend to fall alongside stocks, just when you need the cushion most. Module 10 looks more closely at high-yield bonds and other “bond-like” income products.
Canadian provinces borrow heavily, and their bonds make up a large share of a broad Canadian bond fund, often around a third. They usually pay a small spread over Government of Canada bonds of the same maturity, for two reasons:
For most investors, provincial bonds sit close to federal bonds in practice: high quality, a small extra yield, and a similar role as a cushion. The same is broadly true of US state bonds, which also have tax advantages for US residents.
Educational purposes only; not financial advice. Any bonds, funds, tickers, rates and figures are illustrative examples, not recommendations. Interest rates, deposit-insurance limits and tax rules change, so confirm current details with the issuer, CDIC and your tax authority. Worked examples are not forecasts. Written by Elizabeta Dimoska. Always do your own research and consult a licensed advisor.