In the debt markets, credit spreads are a vital signal, revealing the risk premium investors demand to hold a risky bond over a "safe" benchmark like a U.S. Treasury. But what drives these spreads? A big part of the answer lies in the tug-of-war between default rates and recovery rates.
What’s a Credit Spread?
Simply put, a credit spread is the yield difference between a risky bond (say, a corporate bond) and a risk-free bond of the same maturity. It’s calculated as:
Credit Spread = Yield of Risky Bond - Yield of Risk-Free Bond
For example, if a 5-year corporate bond yields 4.5% and a 5-year Treasury yields 2%, the credit spread is 2.5%. This extra yield compensates investors for the risk that the issuer might default. But how much of that risk is tied to default likelihood versus what’s recovered if things go south?
Default Rates: The Risk of Non-Payment
The default rate is the percentage of issuers who fail to meet their debt obligations over a specific period. When default rates rise, credit spreads tend to widen as investors grow nervous about getting paid back.
Recovery Rates: The Safety Net
Here’s where recovery rates enter the picture. This is the percentage of a bond’s value investors recoup after a default, often through bankruptcy proceedings. Senior secured bonds might recover 60-80%, while unsecured bonds could fetch as little as 20-40%.
The Credit Spread Formula: Tying It Together
Combining the concepts of default rate and recovery rate yields a simplified theoretical model to express the relationship:
Credit Spread = (Probability of Default) × (1 - Recovery Rate)
Let’s break it down:
Probability of Default (PD): The expected probability that a default occurs before maturity.
Recovery Rate (RR): The amount of money recovered by the creditor expressed as a fraction of a bond's principal value at the time of default.
Going back to our previous example, if a bond has an estimated 40% recovery rate, and the credit spread is 2.5%, the market is pricing in a 4.2% chance of default.
Why It Matters
For investors, understanding this interplay is a valuable tool. When credit spreads are widening it is important to determine if it is because borrowers are becoming more likely to default or if because the value of the assets backing the debt is declining in value.
It is important to note that the second formula is an very simplified expression. There are many paths that a debt security can take over the time to maturity that are not captured.
But, by tracking default rates and recovery trends, investors can better decode what credit spreads are whispering about the market.