Measuring Bond Credit Risk with CDS Spreads and Credit Models

Summary

The document considers how to estimate a bond’s price sensitivity to changes in credit risk and whether duration and convexity are sufficient. It suggests using a credit default swap, when one is available on the bond, as a market indicator of credit risk and as a basis for comparing bonds. A separate answer points toward credit pricing models tailored to company characteristics such as size, liquidity, and industry.

The key distinction is between interest rate risk and issuer-specific credit risk. Duration and convexity describe price responses to changes in interest rates; they do not capture idiosyncratic credit events such as a downgrade. The discussion is introductory and gives no formula for translating a CDS spread or rating change into a bond price move. It also does not specify a model, data source, or calibration procedure, so the suggested indicators and modeling direction require further analysis for practical valuation.

Key ideas

• A bond CDS, when available, can provide a market-based indicator of credit risk.
• Credit pricing models may need to reflect issuer size, liquidity, and industry.
• Duration and convexity measure interest rate sensitivity rather than issuer-specific credit events.
• Credit downgrades can affect bond prices through risks that standard rate duration does not capture.
• The document gives no quantitative method for converting a credit change into a price change.

Tags

# How do you quantify credit risk?


# How do you quantify credit risk?












I am trying to figure out how to quantify the change in price on a bond for a change in credit risk. I'm not even sure how to quantify a change in credit risk, but I'm thinking possibly something related to either the debt/equity rating of a corporate bond or a change in the credit rating. If there is a better way, please do include it in your answer.

So, my question is how to determine the price change from a change in the credit risk for a bond? Is there a way to quantify this in any remotely accurate way? If so, how?

Would simple duration/convexity do the trick?

Thanks.

## Answer by wchyk-cyw (score 2)

https://quant.stackexchange.com/a/29589

If there is a CDS on the bond, that might be a good indicator to use, esp. if you want to compare one against another.

## Answer by zglin (score 1)

https://quant.stackexchange.com/a/28021

What you're looking for looks to be more in the realm of a mathematical model (specific to the company's size, available liquidity, and industry). Credit Risk Pricing Models may provide a decent overview of how to build such a model.

Unfortunately duration/convexity will only help you capture the interest rate risk on your bonds, and not any of the idiosyncratic events such as credit downgrades.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.