When evaluating corporate bond spreads, it's essential to understand what they actually reflect.

Essentially, credit spreads should compensate investors for the different risks they face when lending to corporations instead of risk-free entities like governments.

Let's break down these key components.

First, we have the most fundamental component, the expected loss.

Expected loss is a way of estimating the average financial impact of potential defaults in a portfolio.

We calculate this by multiplying the probability of default by the expected loss given default LGD.

Here's an example to illustrate.

Suppose we have 100 clients each borrowing a thousand dollars for one year.

If each client has a 2% probability of default and an expected recovery rate of 0%, our expected loss calculation would look like this 2%, that's the default probability, multiplied by 100%, which is the loss given default.

since there's no recovery.

This gives us an expected loss rate of 2%.

Applied to our $100,000 portfolio, this 2% means a total expected loss of $2,000.

If each client pays a credit spread of 2% on their loan, it generates $20 per loan or $2,000 in total covering our expected losses.

This example simplifies things by assuming uniform default probabilities and no recoveries, but it shows the basic concept of expected loss pricing.

However, corporate bond investors demand more than just compensation for expected loss.

Corporate bond prices fluctuate and mark-to-market risk plays a significant role.

This includes interest rate sensitivity, where bond prices are affected by shifts in credit risk-free market interest rates, and credit spread sensitivity reflecting changes in the perceived credit risk of the issuer.

While compensation for interest rate sensitivity is reflected in the credit risk-free rate, the credit spread should include compensation for credit spread volatility, and the associated uncertainty.

This volatility arises from two sources, issuer specific factors such as changes in the expected loss of an issuer and market dynamics, such as so-called risk off behavior, where investors sell out of credit and move to safe haven assets.

For example, in a risk-off environment, credit spreads tend to widen even if default probabilities remain stable.

When credit spreads widen, the price of corporate bonds falls relative to government bonds creating additional price volatility.

Investors demand compensation for this credit spread risk as it represents a market driven factor beyond expected loss.

Another key component is liquidity risk.

Liquidity in corporate bond markets has significantly decreased since the global financial crisis, especially in secondary markets for lower rated bonds.

With lower dealer inventories, it's harder to buy or sell certain bonds without affecting their prices, particularly during market stress.

This illiquidity demands and additional premium, especially for high yield bonds or less frequently traded investment grade bonds.

To bring all this into perspective, during the financial crisis of 2008 to 2009, annual default rates for investment grade bonds were about half a percent.

Given a 60% loss given default, a one year expected loss rate would imply spreads around 30 basis points.

Yet indices like ItreX and CDX traded much wider illustrating how market conditions and liquidity considerations pushed spread significantly higher than just the expected loss.

Finally, while it is impossible to perfectly split a credit spread into distinct components, understanding the different drivers expected loss, credit spread sensitivity and liquidity risk helps investors better evaluate, created risk, and make informed decisions.