Credit Risk

Fixed Income, LOS weight share 0.8 percent of the 365 Level I learning outcomes.

Fixed IncomeCredit Risk

A downgrade from BBB- to BB+ has not defaulted a single bond, and the exam's favorite trap is a candidate who answers 'default risk' anyway, because the word downgrade sounds so much like the word default.

Before you watch

Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.

1. An analyst calculates a bond's expected loss using a 2% annual probability of default and a 45% recovery rate. The expected loss is closest to:

Answer: A. Loss given default = 1 - recovery rate = 1 - 0.45 = 0.55. Expected loss = PD x LGD = 0.02 x 0.55 = 1.10%... the correct arithmetic gives 1.10%, not 0.90%; recovery rate must first be converted to loss given default (1 minus recovery), never multiplied directly by PD.

2. A corporate bond, previously rated BBB, is downgraded to BB+ after a weak earnings report, with no missed payment. This event is best described as:

Answer: B. Credit migration risk is the risk that a rating changes, here crossing the investment-grade/high-yield boundary (a fallen angel), which widens the spread and lowers the price even though the issuer has not missed a payment. Default risk materializing requires an actual missed payment, which has not occurred.

3. A bond indenture provision prohibits the issuer from paying dividends above a specified threshold without bondholder consent. This provision is best classified as:

Answer: B. A negative (restrictive) covenant prohibits the issuer from taking an action; restricting dividends is a prohibition, not a requirement to act, so it is negative rather than affirmative. The word 'negative' describes the grammatical form of the restriction, not that it harms bondholders, restrictive covenants exist specifically to protect them.

The lesson

The video lesson for this unit is recorded and waiting to be published. Everything it teaches is written out below.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to describe the two components of credit risk, default risk and credit spread risk, describe the four Cs of credit analysis, compare investment grade and high-yield bonds, and describe the documented limitations of credit ratings. No calculation goes beyond multiplying a probability by a loss severity.

Credit risk is broader than the risk of an issuer missing a payment, and the exam's most repeated trap on this module lives in that gap. It has two separate components. Default risk is the probability an issuer actually fails to make a scheduled payment. Credit spread risk is different: the risk that the yield spread over a benchmark government bond simply widens, lowering the bond's price, driven purely by a deteriorating market assessment of creditworthiness with no missed payment required at all. A bond can lose a real, material share of its value from spread widening alone, well before, or even without, any default ever happening.

Expected loss quantifies default risk by multiplying two separate figures together: expected loss = probability of default x loss given default. Loss given default is not the recovery rate itself; it is one minus the recovery rate, the portion of exposure actually lost once default occurs. Skipping that subtraction and multiplying probability of default directly by the recovery rate is the most common calculation error this module produces.

Credit analysis runs through four Cs, and the exam treats every one of them as equally important. Capacity is the most quantitative: cash flow generation and coverage ratios like interest coverage and debt to EBITDA, measuring whether the issuer can comfortably service debt from its own operations. Collateral is the asset backstop, pledged property or equipment giving bondholders a specific legal claim if default occurs, which is why a senior secured bond recovers more than an unsecured one. Covenants are the indenture's contractual protections, affirmative covenants requiring the issuer to act, negative covenants prohibiting it from acting, both protecting bondholders despite the word negative sounding unfavorable. Character is the qualitative read on management's integrity and its track record with creditors. It is not a soft, secondary factor. Strong capacity ratios today did not stop issuers whose management was already misrepresenting results from collapsing regardless.

Investment grade, rated BBB-/Baa3 or above, and high yield, rated below that line, describe probability categories, never certainties. Many high-yield bonds never default in a given year. Some investment-grade bonds do default. A rating is the agency's assessment of relative creditworthiness, not a guarantee of anything. A fallen angel is a bond originally issued investment grade that gets downgraded into speculative grade; a rising star runs the reverse direction, moving from high yield up into investment grade.

Credit ratings carry well-documented limitations the exam tests directly. Ratings lag: agencies update infrequently and update after a credit story has already deteriorated in the market, not before. The issuer-pays model creates a structural conflict of interest, since the agency is paid by the very issuer it is rating. And ratings blend both quantitative and qualitative judgment; they are not a purely model-driven output. A rating downgrade by itself, even one crossing the investment-grade boundary, is credit migration risk, not default risk, unless an actual payment was missed.

The trap

A rating downgrade, even one crossing from investment grade into speculative grade, has not defaulted a single bond by itself; the exam labels this credit migration risk, a distinct and earlier-arriving risk from default risk, and answering 'default risk' because the word downgrade sounds close to the word default is the trap.

Learning outcomes covered by this module

Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.

  1. describe credit risk and its components, probability of default and loss given default
  2. describe the uses of ratings from credit rating agencies and their limitations
  3. describe macroeconomic, market, and issuer-specific factors that influence the level and volatility of yield spreads

Key rules

Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.

LOS 01

Credit risk decomposes into a probability and a severity, and expected loss multiplies the two together

Credit risk has two components: probability of default (PD), the likelihood the issuer fails to make a scheduled payment, and loss given default (LGD), the portion of exposure actually lost if default occurs, equal to one minus the recovery rate. Expected loss equals PD multiplied by LGD, never PD multiplied by recovery rate directly and never PD alone; recovery rate must first be converted into LGD by subtracting it from one before the multiplication is performed.

LOS 01

Credit risk also includes spread risk, which moves bond prices well before any default occurs

Beyond default risk itself, credit risk includes credit spread risk, the risk that the yield spread over a benchmark government bond widens, lowering the bond's price, driven purely by a deteriorating market assessment of creditworthiness with no missed payment required. Spread risk is forward-looking and can produce a large, real price loss on the day the market reprices an issuer's risk, well before, or even without, any actual default.

LOS 02

Credit ratings are a useful ordinal signal but carry well-documented limitations that the exam tests directly

Rating agencies compress a wide range of qualitative and quantitative credit information into a single letter grade, useful for comparing relative creditworthiness and for sorting bonds into investment grade (BBB-/Baa3 and above) versus speculative grade (below that threshold). Their limitations include a documented tendency to lag deteriorating credit quality (ratings are backward-looking, committee-based decisions, while spreads and CDS prices are forward-looking market signals), a conflict of interest under the issuer-pays model (the rated entity pays the rating agency), and the fact that a rating is not itself an investment recommendation nor a guarantee against default.

LOS 03

Yield spreads widen or narrow in response to macroeconomic, market, and issuer-specific factors, and these operate at different levels

Macroeconomic factors (a weakening economy, tightening credit conditions, rising risk aversion) widen spreads broadly across the whole market, not any one issuer. Market-level factors, such as overall demand for and supply of credit risk, or a general flight to quality, move spreads for entire rating categories or sectors together. Issuer-specific factors, deteriorating fundamentals, a ratings downgrade, weaker coverage ratios, move an individual bond's spread relative to its peers. A widening spread attributed to only one of these levels when facts point to another is a common source of exam error; check which level the facts describe before answering.

The trick

Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.

Expected loss requires converting recovery rate to LGD before multiplying by PD

LGD = 1 - recovery rate, then Expected Loss = PD x LGD. Skipping the subtraction step and multiplying PD directly by the recovery rate is the most common calculation error on this module.

A downgrade is credit migration risk, not default risk, unless a payment was actually missed

Default risk requires an actual missed payment. A rating change alone, even crossing the investment-grade boundary (a fallen angel), is credit migration risk, a distinct and earlier-arriving risk.

Negative covenants protect bondholders; the word 'negative' describes the grammar, not the effect

A negative covenant prohibits an issuer action (no dividends above a threshold, no new senior debt); it exists specifically to protect bondholders, it is not a harmful term despite the word 'negative.'

The method

Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.

  1. For an expected-loss question, first convert any given recovery rate to loss given default (1 minus recovery rate), then multiply by probability of default.
  2. For a rating-change scenario, check whether a payment was actually missed; if not, classify the event as credit migration risk, not default risk.
  3. For a rating-agency-limitation question, choose among the four documented limitations: lag versus market signals, issuer-pays conflict of interest, and rating as non-guarantee, rather than inventing an unsupported criticism.
  4. For a covenant question, classify by grammatical form: an obligation to act is affirmative, a prohibition on acting is negative, independent of how favorable or unfavorable the term feels.
  5. For a spread-widening question, identify whether the described driver operates at the macroeconomic, market, or issuer-specific level before selecting the answer.

One card

Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.

Practice questions

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.

Question 1Exam level

An analyst is evaluating a bond issuer's credit quality. She examines cash flow generation, debt-to-EBITDA ratio, and interest coverage ratio. Which of the 4 Cs of credit is she primarily assessing, most likely?

How sure are you?

Correct: B. The correct answer is Capacity.
A. Character sounds like the qualitative/overall assessment of management quality, which could include financial ratios. Character is specifically management integrity and history of debt repayment. Not quantitative financial ratios.
C. Covenants include financial maintenance tests (e.g., maintaining minimum coverage ratios), which are checked via ratio analysis. Covenants are contractual restrictions in the bond indenture. Measuring whether a company can service debt is a Capacity assessment, not a Covenant assessment.

Unit: credit-risk

Question 2Exam level

A bond currently rated BBB by S&P is downgraded to BB+. This downgrade is most likely described as an example of:

How sure are you?

Correct: B. The correct answer is Credit migration risk.
A. A downgrade sounds like something bad has happened to the credit, which candidates associate with 'default risk.'. Default risk materializing means the issuer actually failed to pay. A downgrade is a rating change, not a payment failure.
C. Spread duration risk involves price sensitivity to spread changes, and a downgrade widens spreads. Spread duration describes price sensitivity mechanics. The event described is the rating change itself. Credit migration risk.

Unit: credit-risk

Question 3Exam level

The expected loss on a bond is most likely calculated as:

How sure are you?

Correct: B. The correct answer is Probability of default × loss given default.
A. Bond price seems like the relevant monetary exposure to multiply by probability of default. Expected loss uses LGD (the fraction of exposure lost), not the full bond price. If recovery is 40%, you don't lose the full price.
C. LGD and recovery rate are related, and dividing seems like a formula operation. LGD = 1 − Recovery Rate; you do not divide by recovery rate. And expected loss requires PD as a multiplier.

Unit: credit-risk

Question 4Exam level

A bond indenture contains a provision that limits the issuer from paying dividends above a specified threshold without bondholder approval. This provision is most likely classified as a:

How sure are you?

Correct: B. The correct answer is Negative covenant.
A. 'Affirmative' sounds like a strong, active form of bondholder protection, which dividend restrictions seem to be. Affirmative covenants require the issuer to take action (do something positive). Negative covenants prohibit actions. Restricting dividends = prohibition = negative covenant.
C. Character involves management behavior, and how dividends are paid relates to management decisions. Character is the analyst's qualitative assessment of management integrity, not a contractual provision in the bond document.

Unit: credit-risk

Question 5Exam level

An investment-grade bond has a modified duration of 6.0 and a credit spread of 150 basis points. If the credit spread widens by 50 basis points, the approximate price change due to spread widening is closest to:

How sure are you?

Correct: B. The correct answer is −3.00%.
A. −0.83% comes from dividing the spread change (50 bps) by the current spread level (150 bps) then adjusting, a nonsensical operation candidates attempt when confused. Price change uses duration × change in yield, not the ratio of yield changes. The formula is −D × Δy.
C. −9.00% comes from 6.0 × 1.50% (mistakenly using the full credit spread of 150 bps instead of the change of 50 bps). The question asks for the price change due to spread WIDENING by 50 bps, not the total spread level. Always use the change, not the level.

Unit: credit-risk

Question 6Exam level

Which of the following is MOST likely a limitation of credit ratings issued by major rating agencies?

How sure are you?

Correct: B. The correct answer is Ratings may lag deterioration in an issuer's creditworthiness.
A. You might know that rating models use financial ratios and assume quantitative = model-only. Rating agencies explicitly incorporate qualitative factors: management quality, industry position, competitive environment. The 4 Cs framework is qualitative as much as quantitative.
C. If ratings are real-time, they'd be more reliable; candidates might assume this is a true characteristic they haven't heard is a limitation. This statement is false. Ratings are NOT updated continuously. Real-time updating would actually be a positive feature, not a limitation.

Unit: credit-risk

Question 7Exam level

A 'fallen angel' in the bond market most likely refers to a bond that:

How sure are you?

Correct: B. The correct answer is Was originally issued as investment grade but downgraded to speculative grade.
A. A default is the ultimate negative credit event, and falling from grace to default sounds like a 'fallen angel.'. Fallen angel has a specific technical definition: crossing the IG/HY rating boundary. A defaulted bond is not called a fallen angel.
C. Interest rate declines can cause bond restructuring, which could be confused with a credit deterioration. Coupon rates on existing bonds are fixed and do not change with interest rate movements. Fallen angel is strictly a credit rating event.

Unit: credit-risk

Question 8Exam level

When evaluating the character of a bond issuer, a credit analyst would MOST likely examine:

How sure are you?

Correct: B. The correct answer is Management's track record and history of debt repayment.
A. Liquidity ratios are part of credit analysis and could be seen as a measure of a company's financial 'character.'. Liquidity ratios (current ratio, quick ratio) assess the ability to pay short-term obligations. This is Capacity, specifically short-term capacity.
C. Debt covenants relate to how the borrower is constrained in their behavior, which overlaps conceptually with trustworthiness. Covenants are contractual provisions in the bond indenture. That is the Covenants C. Character is about management's track record independent of formal contractual constraints.

Unit: credit-risk

Question 9Above the exam

Bond Issuer X has a lower probability of default than Bond Issuer Y over the next year, but Issuer X's bonds are unsecured while Issuer Y's bonds are secured by specific collateral with a loss-given-default estimated at only 20% (versus 60% for Issuer X's unsecured bonds). Combining probability of default with loss given default, the bond with the higher overall expected loss is most likely:

How sure are you?

Correct: B. Expected loss combines BOTH probability of default (POD) and loss given default (LGD): Expected loss = POD x LGD. A bond with a lower POD can still have a HIGHER expected loss than a bond with a higher POD if its LGD is disproportionately larger (as with Issuer X's unsecured status producing a 60% LGD versus Issuer Y's secured 20% LGD); the two components must be combined, not evaluated in isolation, to determine which bond carries more overall credit risk in expected-loss terms.
A. Probability of default alone does not determine expected loss; the RECOVERY characteristics of the bond (captured by loss given default) are an equally necessary second input, and ignoring LGD here specifically misses why Issuer X's unsecured, high-LGD bond could actually carry the higher expected loss despite its lower default probability.
C. Unsecured status raises LGD (lower recovery in default) but does not automatically make a bond riskier in EVERY respect, including probability of default itself, which the question states is LOWER for Issuer X; expected loss requires combining both POD and LGD, not assuming one characteristic dominates every dimension of credit risk.

Unit: credit-risk

Question 10Above the exam

A corporate bond's credit spread widens from 100 bps to 160 bps over a period during which the issuer's fundamental credit quality (leverage, coverage ratios, business risk) is unchanged, but overall market risk aversion has increased sharply (a 'flight to quality'). Combining the components of a credit spread with this scenario, the spread widening is most likely primarily attributable to:

How sure are you?

Correct: B. A credit spread reflects more than just the issuer-specific expected loss; it also includes compensation for liquidity risk and the market's general risk appetite (a market-wide risk premium that can move for reasons unrelated to any one issuer). Since the question specifically states the issuer's own fundamental credit quality is unchanged while market-wide risk aversion has increased, the spread widening most likely reflects this market-wide component, not a genuine change in the issuer's own default or recovery outlook.
A. The question explicitly states the issuer's fundamental credit quality (leverage, coverage, business risk) is UNCHANGED; attributing the spread widening to a genuine deterioration in issuer-specific expected loss directly contradicts that stated premise.
C. A bond's coupon rate is typically fixed at issuance and does not change over the bond's life for a standard fixed-rate bond; coupon changes are not a driver of credit spread movements at all in this context, market perception of risk is.

Unit: credit-risk

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