Fixed Income Securities, 4th Edition

CHAPTER 14Corporate Debt and Credit Default Swaps

Corporations borrow money to fund their operations, transactions (e.g., mergers and acquisitions), and changes to capital structure (e.g., refinance existing debt, stock repurchases). The loans and bonds used to raise these funds are subject to credit risk, because corporations may not make good on their promises to pay interest and repay principal. Lenders, in turn, require compensation for bearing credit risk in the form of higher returns. The cash flows of credit default swaps (CDS) also depend on the payment or nonpayment of debt obligations but are not themselves obligations of corporate issuers. In other words, through CDS contracts, market participants trade corporate credit risks with each other. While this chapter focuses mostly on corporate debt, much of the discussion applies to sovereign and municipal debt as well, because the debt obligations of many governments have at times been perceived as subject to nontrivial probabilities of default.

Many market participants rely to some extent on rating agencies to measure the credit risk of borrowers and their loans and bonds. The long‐term debt ratings classifications of the three major rating agencies in the United States are given in Table 14.1. More granular breakdowns of each of these broad ratings classifications are also available, and short‐term debt has its own, separate scales.¹

TABLE 14.1 Long‐Term Debt Ratings Classifications. The Ratings in Each Entry Are ...