Corporate Bonds, Ratings, and Credit Spreads (Chapter 19, Part 1)
Book: Fixed Income Securities: Tools for Today’s Markets | Author: Bruce Tuckman & Angel Serrat | ISBN: 978-0-470-89169-8
Previous: Swaption Skew, SABR, and Option Pricing Theory (Chapter 18, Part 2) | Next: Credit Default Swaps and the CDS-Bond Basis (Chapter 19, Part 2)
Chapter 19 is where the book stops pretending all bonds pay on time. Corporate credit is messy, political, and full of spread metrics that sound interchangeable but are not. Part 1 sets up the market, the data, and the spread math. Part 2 covers CDS.
Corporate Debt in the Real World
Companies borrow through commercial paper (short, often discount paper), medium-term notes (custom terms, shelf registration), and standard coupon bonds (SEC registered, often callable). Floating rate notes pay LIBOR plus a spread, sometimes with leverage or rating-linked spreads.
The indenture matters. Senior vs subordinated, secured vs unsecured, covenants on leverage and dividends. In bankruptcy, strict priority is the theory. Negotiation and courts are the practice. Lehman’s 2011 plan is the textbook horror story: recovery rates ranged from about 12% to 52% depending on claim class, even within the same holding company.
Ratings, Defaults, and Recovery
Moody’s, S&P, and Fitch rate from investment grade (Baa/BBB-) down to default. Moody’s historical data (1970-2009) shows cumulative 15-year default rates rising sharply as ratings fall: about 0.5% for A, 29.7% for Ba.
Recovery on senior unsecured debt averages around 40% for many rating buckets. That 40% assumption shows up everywhere in credit math. But averages lie. Recovery spikes when defaults cluster (2008-2009). It also depends on capital structure: subordinated debt in a lightly levered issuer can recover far more than the same claim in a debt-heavy capital structure.
Default rates are volatile and systemic. S&P data from 1990-2009 shows overall defaults swinging from under 0.5% to about 4%, with high-yield defaults hitting 15%+. The 2007-2009 crisis matched the Enron/WorldCom spike in rate, but not in notional destroyed.
Ratings agencies are controversial. Regulators embedded ratings in Basel rules, money market fund standards, and bank capital. Issuers pay for ratings, which invites conflict-of-interest talk. Dodd-Frank tried to remove rating references from rules and expose agencies to liability. The ABS market briefly froze when agencies refused to attach ratings to registrations. Basel III still references ratings. The reform is incomplete.
Credit Spreads: Yield Spread vs Bond Spread
The yield spread (bond yield minus Treasury or par swap yield) is easy but flawed. Coupon effects distort it (Chapter 3). Embedded call options inflate yield and make credit look worse than it is.
The bond spread (OAS for callable bonds) finds the spread over a benchmark curve that reprices the bond assuming no default. Since the market price already discounts default risk, the spread is a cleaner credit measure.
European sovereign spreads in late 2010 made this vivid. Spreads vs LIBOR were negative for Germany, Finland, Netherlands, and France (sovereigns better than banks). Spreads vs OIS were positive. Greece, Ireland, Portugal, and Spain sat far wider. Same bonds, different benchmark, different story.
Asset Swap Spreads
The par-par asset swap is the street favorite. Buy the bond, finance at par via repo, receive fixed on a swap against LIBOR plus spread s_PAR on 100 face. Net result: LIBOR + s_PAR minus repo, with minimal rate risk if the bond does not default. Credit risk stays.
Fair s_PAR solves a present value equation tying bond price P to swap annuities. Lower P means higher spread. That is the intuition: credit shows up in the asset swap spread.
The market-value asset swap runs the same economics but puts the spread on notional P instead of 100. Same cash flows, different collateral profile. Premium bonds favor market-value swaps (no upfront swap payment). Discount bonds favor par swaps.
A toy 2-year 4.25% bond at 90 with forwards at 1% and 2% shows how measures diverge:
| Measure | Value |
|---|---|
| Yield spread | 8.52% |
| Bond spread/OAS | 8.53% |
| Par asset swap | 7.86% |
| Market-value asset swap | 8.73% |
Bond spread puts credit in the discount denominator. Asset swap puts it in the coupon numerator. Both say “lots of credit risk” on a 90-priced bond with a 4.25% coupon.
KB Home: Distress in Numbers
KB Home 5.75s due Feb 2014 traded at 68.66 on Nov 10, 2008. Par swap was 3.71%. Yield spread: 11.4%. Bond spread: 11.5%. Par asset swap: 9.2%. Market-value asset swap: 13.4%. This bond comes back in Part 2 for negative basis trades.
Spreads vs Realized Defaults
Link spread s to constant hazard rate h and recovery R (ignore risk premium for a moment):
s ≈ h(1 - R)
Moody’s five-year cumulative defaults with 40% recovery imply spreads that, for junk, bracket historical market wides and tights. For investment grade, even the tightest market spreads look generous versus realized defaults. Either the market overestimates default, or there is a large credit risk premium. Probably both.
Hazard rates bridge bond spreads to CDS pricing in Part 2. If you can express default probability as h and recovery as R, you can compare cash and synthetic credit on equal footing.
What Part 1 Leaves You With
Corporate bonds are not Treasuries with extra yield. They are contracts with priority, covenants, call options, and financing constraints. Yield spread is a starting point. Bond spread and asset swap spread are the working tools. Recovery and hazard rates connect spreads to default math.
Next up: CDS mechanics, up-front payments, the CDS-bond basis, and the KB Home negative basis trade that looked free until financing said otherwise.