Corporate Bond

A corporate bond is a loan to a company. Like a government bond it pays coupons and returns principal — but a company can genuinely go bust, so it must offer extra yield over government bonds. That extra is the credit spread, and it is the heart of the product.

The market splits into two worlds by rating: investment grade (BBB− and above — stable firms, modest spreads) and high yield or "junk" (BB+ and below — riskier firms, fat spreads and equity-like behaviour in downturns).

If default happens, bondholders don't lose everything: they queue up in bankruptcy and typically recover some fraction of face value — historically ~40% on average for senior unsecured bonds, more for secured, less for subordinated.

Spread measures

• G-spread: yield minus the interpolated government yield.
• Z-spread: the constant spread over the swap/discount curve equating price to cash flows — the standard analytic.
• OAS: Z-spread after stripping embedded options (most corporates are callable).

What drives spreads

Expected default losses explain only part of spreads (the "credit spread puzzle"); the rest is compensation for illiquidity, downgrade risk, and the fact that defaults cluster in bad times exactly when losses hurt most. Spreads breathe with the economy: widening in recessions, grinding tighter in calm ones.

Structure matters

• Seniority: secured → senior unsecured → subordinated; each tier has its own spread and recovery.
• Covenants: promises limiting the issuer (debt caps, asset sales). High-yield bonds carry heavy covenant packages; their erosion ("cov-lite") is a cycle indicator.
• Calls: HY bonds are usually callable after a few years — investors price to the worst call date.

Reduced-form pricing

With hazard rate (default intensity) \(\lambda_t\) and recovery \(R\), the survival-weighted PV of a credit-risky bond:

The credit triangle \(s \approx \lambda(1-R)\) is the workhorse approximation linking spread, default intensity and loss severity. Calibrate \(\lambda\) from bond prices or CDS; differences between the two define the CDS-bond basis.

Structural view

Merton: equity is a call on firm assets, debt is a risk-free bond minus a put on those assets:

This explains why spreads widen as equity falls and vol rises, and underpins quantitative default models (distance-to-default à la KMV).

Risk metrics

Credit portfolios are managed on spread duration (price sensitivity to spread moves, \(\Delta P/P \approx -D_s\,\Delta s\)) and DTS (duration times spread) — recognising that spread volatility is proportional to spread level. Jump-to-default risk is measured separately: JTD ≈ position × (1 − R).

New-issue mechanics

Primary markets price at a spread concession to secondaries; the concession, order-book coverage and post-break performance are the market's live health indicators.