Credit Analysis

Why this matters

The first half of this track priced bonds as if every payment were certain. For Treasuries that's a reasonable working assumption. For every other borrower it's the main question. A corporate bond yielding 7% beside a Treasury yielding 5% is offering two points for bearing the chance of not being paid, and the investor needs some way to judge whether two points is enough. That judgment is credit analysis. Debt, Covenants, and Credit Ratings looked at a company's debt from the shareholder's side. This lesson takes the lender's.

What there is to lose

A default rarely means losing everything. Lenders usually get something back, through a sale of assets or new securities in a restructured company, as Bankruptcy and Restructuring describes. The share they get back is the recovery rate. Two numbers therefore describe credit risk, and their product is the expected loss.

Expected loss = Probability of default × (1 − Recovery rate)

A bond with a 10% chance of defaulting over its life and an expected recovery of 40% has an expected loss of 10% × 60% = 6% of the amount lent. Both inputs are estimates, and they pull on different parts of the analysis. The probability of default depends on the borrower: its business and its debts. The recovery depends on the bond: whether it's secured, and where it ranks among the borrower's other debts.

Default itself comes in more than one form. In 2023, missed interest or principal payments made up 22% of the defaults S&P Global Ratings recorded among the companies it rates, and bankruptcy filings about 19%. More than half, 54%, were distressed exchanges, in which lenders accept new terms or new securities worth less than they were owed.¹

Credit ratings

A credit rating is an agency's opinion of how likely a borrower is to meet its obligations. S&P describes its issuer rating as a forward-looking opinion about an obligor's overall creditworthiness, focused on its capacity and willingness to meet its financial commitments as they come due.¹ In the US, rating agencies register with the SEC as nationally recognized statistical rating organizations, or NRSROs. Eleven were registered as of March 2026, among them S&P Global Ratings, Moody's Investors Service, and Fitch Ratings.²

Bonds rated Baa or BBB and better are investment grade, and those rated Ba or BB and lower are high yield.³ Agencies add finer steps within each letter, a plus or minus at S&P and Fitch and a number at Moody's.

What the ratings have meant

A rating is an opinion, and opinions can be scored. S&P publishes the default record of every company it has rated since 1981.

Rating at the start	Within 1 year	Within 5 years	Within 10 years	Within 15 years
AAA	0.00%	0.34%	0.68%	0.86%
AA	0.02%	0.28%	0.67%	0.93%
A	0.05%	0.41%	1.07%	1.62%
BBB	0.14%	1.38%	2.90%	4.07%
BB	0.57%	5.88%	10.69%	13.32%
B	2.98%	15.75%	22.18%	25.38%
CCC and below	25.98%	46.65%	50.64%	52.65%
All investment grade	0.08%	0.78%	1.72%	2.42%
All speculative grade	3.52%	13.70%	19.27%	22.12%

Global corporate average cumulative default rates from S&P Global Ratings.¹ The figures count companies, whatever their size.

Three things in the table are worth carrying away.

• The ranking has held. From AA downward, each step down the scale has gone with a higher default rate at every horizon in the table. That's what a rating is for. Only AAA and AA are too close to tell apart.
• The big step is at the investment grade line. Within five years, 1.38% of BBB issuers defaulted and 5.88% of BB issuers did, more than four times as many. The line between the two isn't a formality.
• Time matters as much as the letter. A BBB issuer's chance of defaulting was about one in 700 over a year and about one in 25 over fifteen. A rating says little about a horizon unless you name the horizon.

Defaults come in waves

Those are averages over forty-three years, and the years weren't alike. The share of speculative-grade companies defaulting in a single year was 11.02% in 1991, 9.70% in 2001, and 9.89% in 2009. It was 0.91% in 2007 and 1.68% in 2021. Investment-grade defaults stayed rare throughout: the worst year in the record was 2008, at 0.42%.¹

This clustering is what makes credit risk hard to diversify. Holding a hundred high-yield bonds protects against one company's bad luck. It doesn't protect against a recession, when many of the hundred weaken together. Company, Sector, Market, and Liquidity Risk drew the same line between the risk that diversification removes and the risk it doesn't.

Ratings move

A rating describes a company today. In an average year, about 87% of BBB-rated companies were still rated BBB a year later. About 3% had been upgraded to A, and about 4% had fallen below investment grade or defaulted, with the rest no longer rated.¹ A company downgraded from investment grade to high yield is called a fallen angel, and the change is more than a label, since that line is where default rates step up.

Companies seldom go straight from a good rating to default. Credit quality tends to deteriorate on the way, and a defaulting issuer is most often rated CCC+ or lower immediately beforehand. Among companies first rated B, the majority of those that defaulted did so within four years.¹

There are exceptions, and they're instructive. In 2023, all but two of the defaulters that S&P rated at the start of the year were speculative grade. The two were Silicon Valley Bank and its parent, rated in the BBB category that January.¹ Duration and Convexity mentioned what went wrong there. A rating summarizes what's known and judged likely. It can't promise.

Doing the analysis yourself

Ratings are a starting point. The underlying questions are few, and the numbers come from the statements covered in Part 3.

1. Does profit cover the interest? Interest coverage is operating profit divided by interest expense. A company earning six times its interest can absorb a bad year. One earning one and a half times can't.
2. How large is the debt against the cash flow? Debt divided by EBITDA is the usual measure, along with free cash flow as a percentage of debt, which shows how fast the debt could be paid down.
3. When does the debt fall due? Most company debt is repaid by borrowing again. A large maturity in the next year or two is a test the company has to pass in whatever market exists then.
4. Where does this bond rank? Secured or unsecured, senior or subordinated. This sets the recovery if things go wrong.
5. How steady is the business? The same ratios are safer in a company with stable demand than in one whose profits halve in a downturn.

	Alder Valley Foods	Corran Leisure Group
EBITDA	500	300
Operating profit	380	170
Interest expense	60	110
Total debt	1,200	1,650
Free cash flow	180	25
Debt due within a year	100	700
Interest coverage	6.3 times	1.5 times
Debt to EBITDA	2.4 times	5.5 times
Free cash flow to debt	15.0%	1.5%

Alder Valley could repay its debt from free cash flow in under seven years and covers its interest six times. Corran covers its interest with little to spare, generates almost no cash after investment, and has $700 million to refinance within a year. Its lenders are relying on other lenders.

Stress it

Today's ratios describe a normal year. A lender's real question is what a bad one looks like. Suppose EBITDA falls 30% at both companies, with depreciation and interest unchanged.

	Alder Valley Foods	Corran Leisure Group
EBITDA	350	210
Operating profit	230	80
Interest coverage	3.8 times	0.7 times
Debt to EBITDA	3.4 times	7.9 times

Alder Valley is weaker and still comfortably paying. Corran's operating profit no longer covers its interest, in the same year it needs new lenders for $700 million. Neither company has defaulted in this example. One of them now depends on events going well.

People keep buying food in a downturn and can put off a holiday, so the same 30% shock is a harsh assumption for the first company and perhaps a mild one for the second. Ratios and judgment about the business have to be read together.

From default rates to a required yield

The historical table can be turned into a rough hurdle. Take the five-year default rates, convert each to a yearly rate, and assume that 40% is recovered in a default. The recovery figure here is an assumption for illustration, and actual recoveries vary widely with the bond's ranking.

Rating	Defaulted within 5 years	As a yearly rate	Yearly loss at 40% recovery
A	0.41%	0.08%	0.05%
BBB	1.38%	0.28%	0.17%
BB	5.88%	1.20%	0.72%
B	15.75%	3.37%	2.02%
CCC and below	46.65%	11.81%	7.09%

On these figures, a B-rated bond has to yield about two points more than a Treasury just to break even with one over a typical five years, before any reward for the risk. A BBB bond needs less than a fifth of a point. Extra yield beyond the expected loss is the investor's pay for uncertainty, for the clustering of defaults in bad times, and for bonds that are harder to sell.

Whether the market actually pays more than the expected loss, and how much, is the subject of Credit Spreads.

Key takeaways

• Expected loss is the probability of default times the share not recovered.
• Ratings rank issuers by default risk, and the record since 1981 shows the ranking has held.
• Default rates rise sharply below investment grade and grow with the time horizon.
• Defaults cluster in bad years, so they can't be fully diversified away.
• Ratings change, and issuers are usually downgraded well before they default.
• An investor's own check: interest coverage, debt against cash flow, the maturity schedule, the bond's rank, and how the numbers hold up in a bad year.

Check your understanding

A bond has an estimated 20% chance of defaulting over its life. If it defaults, lenders expect to recover 30% of what they're owed. What's the expected loss?

1. 6%, which is the 20% chance of default times the 30% recovered.
2. 20%, since the recovery isn't known until a default has happened.
3. 14%, which is the 20% chance of default times the 70% not recovered.

Two companies each have debt of four times EBITDA and cover their interest three times. One sells groceries and the other sells luxury holidays. Which is the better credit, and why?

1. The grocer, because its profits are likelier to hold up in a bad year.
2. Neither, because identical ratios always mean identical credit risk.
3. The holiday firm, because luxury businesses earn higher profit margins.

What's next

Default rates say what credit risk has cost. Credit Spreads looks at what the market has paid investors to bear it, and how that payment has swung.