One of the most fundamental concepts in finance is the relationship between risk and return.

Essentially, when investors take on additional risk, they expect to be compensated with adequate returns.

In the world of credit investing, this means understanding the underlying credit risk before deciding if the potential returns are enough.

While we won't dive deep into credit risk analysis here, let's touch on the main areas that investors typically consider when assessing credit risk.

These can be divided into two categories.

The first category is the general issuer risk.

This category includes factors that affect the overall financial health of the issuing company.

That is the company issuing the bond within general issuer risk.

Further risk types can be considered.

First, there is business risk.

This involves analyzing the company's business strategy and how it impacts the stability of the company's cash flows.

For example, a company with a high appetite for mergers and acquisitions might face more uncertainty in cashflow stability, and there's also financial risk.

This is about assessing the company's funding structure and leverage.

How much debt does the company have relative to its assets and its equity? High leverage can increase vulnerability to economic downturns affecting the company's ability to meet its debt obligations, and of course, macro drivers.

Here we look at the broader economic environment considering factors such as foreign exchange risk or interest rate risk that could impact the company's cash flows and profitability.

These factors together influence the issuer's probability of default.

Essentially, the risk of the issuer failing to meet its obligations.

However, assessing credit risk isn't only about estimating the probability that something could go wrong, and this brings us to the second category, the issue specific risk.

Because if a borrower does default, the question then is what happens next? Typically, in a default scenario, a liquidator is appointed to sell off the company's assets and use the proceeds to repay its debts as far as possible.

However, not all creditors are repaid equally, and not all debts are repaid in full.

While all data investors have a claim on the company's assets and cash flows, the Priority of these claims depends on the type of debt held by investors categorized as secured or unsecured, and further divided by seniority.

Consequently, while the probability of default may be the same across all bonds issued by the same entity, the amount recovered, and therefore the realized loss can vary depending on the specifics of each bond.

That's where issue specific risk comes into play.

Secured debt instruments are backed by a specific form of collateral.

For example, the company's property or equipment pledged by the issuer if the company defaults secured creditors have a legal right to seize and sell the collateral to recover their investment.

Because of this added security, secured debt generally represents a lower risk to investors.

Unsecured debt is not backed by specific collateral and only provides creditors with a general claim on the issuer's assets. Within unsecured debt, there's a hierarchy.

Holders of senior unsecured debt have the first claim on the issuers general assets after any specific collateral has been allocated to the secured debt holders.

This means that while secured creditors are prioritized for the collateral, senior unsecured debt holders have the highest priority on any remaining general assets.

in the event of default. Holders of subordinated or junior debt are the last to be paid in a default scenario, making it the riskiest form of debt.

In a default situation, if the total debt exceeds the value of the company's assets and cash flows, creditors are repaid in a waterfall structure.

Security debt holders have priority up to the value of their collateral.

With any shortfall ranking alongside senior unsecured debt, subordinated debt is only repaid if there are remaining funds after satisfying the higher priority claims of secured and senior unsecured debt holders.

Now, let's introduce the terms Loss.

Given default, LGD and recovery rate, RR. LGD represents the percentage of the original investment that investors lose if the issuer defaults.

In simple terms, LGD is calculated as one minus the recovery rate.

The recovery rate is the portion of the original investment that creditors actually recover in the event of default.

Here's a quick example.

Suppose a company defaults on a 1000 par value bond.

If in the event of default creditors recover 400 of that amount, the recovery rate is 40%.

Therefore, the LGD is one minus 40% or 60%.

In other words, investors would lose 60% of their investment.

Recovery rates are typically higher for secured debt as it is backed by specific collateral, whereas unsecured and subordinated debt often have lower recovery rates due to their lower priority in the repayment hierarchy.

It's important to note that actual recovery rates often aren't known until long after the default event.

As the liquidation and repayment process can take time until the final recovery rate is determined, the bonds can still be traded, but markets will operate on an expected recovery rate, which is an estimate based on factors such as the issuers, assets, collateral, and other risk considerations.