Topic · Core Finance & Asset Classes
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67 articles · 10 checkpoints · 42 deeper reads · 15 reference notes
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Lending money has a lopsided payoff, a small fixed gain against a large possible loss. Credit risk is the study of that lopsidedness, and it reduces to three questions: how likely is default, how much is lost when it happens, and how much is owed at the time.
Unlike a stock, a company's debt is scattered across dozens of separate bonds, most of which trade a handful of times a day if that, through dealers rather than on an exchange. Understanding why it works this way explains most of what looks strange about credit markets.
The extra yield a corporate bond pays over Treasuries is not just compensation for the chance of default, most of it, historically, is compensation for bearing that risk at all, and separating the two is how credit desks decide whether a bond is cheap.
The extra yield a borrower pays over the risk-free rate. It looks like compensation for default, but most of it is payment for uncertainty and illiquidity, and it is the number credit traders actually trade.
A lender should price in its average losses through provisions, and hold capital against the losses that are worse than average. Confusing the two, pricing for the average, holding capital for the average, is how banks run out of capital exactly when they need it.
When a below-investment-grade company needs to borrow a large amount, no single bank wants to hold the whole loan. The syndicated loan market exists to split it among many lenders, and the resulting instrument, floating-rate and senior-secured, has become its own large asset class.
Two separate numbers that everyone merges into one vague sense of "risky". How likely default is, and how much you lose when it happens, are estimated differently, move differently, and must never be blended.
A company's stock and its bonds are two different bets on the same underlying business, priced by two different sets of investors who don't always agree. Capital structure arbitrage is the trade that bets they'll converge, using the Merton model as the bridge between them.
Two companies rarely default for identical, coordinated reasons, yet their default probabilities still move together, because both are exposed to the same economy. The asset threshold model turns that intuition into a number you can actually compute.
When a company can't pay its debts but wants to avoid bankruptcy court, it renegotiates with lenders directly, and the fine print of who agreed to what, and who got left out, has turned into some of the ugliest fights in modern credit markets.
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