Risk and Credit Analysis · Bonds Explained

Separate three questions

Default asks whether contractual obligations are met. Recovery asks how much value creditors ultimately receive after a default or restructuring. Liquidity asks what price and size can be traded when you need to act. They interact, but one measure cannot replace all three.

A downgrade can affect price before default. A solvent issuer’s bond may also be difficult to sell if few participants trade that particular issue.

Calculate a simple expected loss

Assume a hypothetical one year default probability of 2% and a loss of 60% of exposure if default occurs. The simplified expected loss is 2% × 60% = 1.2% of exposure, or $120 on $10,000.

This is a probability weighted average under stated assumptions. It does not mean you will lose exactly $120, nor does it identify a fair yield by itself. A single realised outcome could be no default or a much larger loss. Timing, recovery uncertainty and market compensation also matter.

Stress the recovery assumption

If recoverable assets shrink during an industry downturn, recovery can fall just as default probability rises. Collateral value should therefore be tested in a difficult environment, not only at today’s appraisal.

A claim described as secured may still face legal costs, delays or collateral shortfalls. Record the expected recovery timing as well as the percentage because a delayed receipt is worth less today.

Ask what can actually trade

A screen may display an evaluated price rather than a firm executable bid. Request a quote for your trade size and compare recent transactions where available. A wide gap between buying and selling prices is a direct cost of changing your position.

Plan liquidity before stress arrives. Concentrating near term spending money in thinly traded bonds can turn a temporary market disruption into a forced loss.

Try it yourself

A simplified scenario uses 3% default probability and 40% recovery. What is expected loss as a percentage of exposure?

Show the worked answer

Loss given default is 60%, so expected loss is 3% × 60% = 1.8%. This is a model average, not a guaranteed or maximum loss.

Further reading

Educational material. Examples are hypothetical and do not recommend a security or a personal allocation. Contract terms and market conventions vary.

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