Promised cash flows are not guaranteed cash flows.

By the end of this lesson, you should be able to:

• 1Explain why non-government bonds carry default risk.
• 2Define default and distinguish promised payoff from expected payoff.
• 3Read the simplified Moody's, S&P, and Fitch rating scale.
• 4Distinguish investment grade from non-investment grade.
• 5Interpret a corporate bond spread over Treasuries.
• 6Explain why a corporate spread is not just default probability.
• 7Distinguish promised YTM from expected YTM.
• 8Define default premium and risk premium.
• 9Calculate promised YTM and expected YTM for a risky zero-coupon bond.
• 10Explain why securitization can repackage risk and what it requires.
• 11Explain why senior structured claims can lose value when correlation, liquidity, and model assumptions change.

If a Treasury yield rises, the move may reflect interest rates, inflation expectations, or liquidity. If a corporate bond yield rises, the move may also reflect credit fear: investors are demanding more compensation because they are less confident the issuer will pay.

For riskless debt, promised cash flows are treated as arriving with certainty. For risky debt, the promised payment is not the same as the expected payment. The promised payoff is what the contract says. The expected payoff is the probability-weighted payoff after accounting for default and recovery. The price is what investors pay today for that uncertain payoff.

Non-government bonds carry default risk. Credit ratings by agencies provide indications of the likelihood of default by each issuer. Ratings are opinions, not guarantees. Investment grade generally means Baa3 / BBB− or higher. Non-investment grade is also called speculative grade or high yield.

Lower-rated bonds usually promise higher yields. But a higher promised yield is not automatically a higher expected return. The extra yield may compensate for a higher probability of not receiving the promised cash flow. As debt becomes very risky, it starts to behave more like equity: payoffs become uncertain, bondholders may become residual claimants in distress, and promised fixed-income cash flows become economically less "fixed."

A common measure of credit compensation compares a corporate bond yield to a Treasury yield of similar maturity. For example, the Moody's Baa yield minus the 10-year Treasury yield. This spread measures extra promised yield investors require for Baa corporate bonds over Treasuries. But a corporate spread can reflect many things: expected default loss, risk aversion, liquidity, taxes, systematic risk, embedded options, market stress, and pricing or model error.

A corporate spread is not "just default probability." Empirical research has examined what drives corporate spreads. The findings consistently show that default explains only part of the spread — the rest includes liquidity, taxes, systematic risk, embedded options, market segmentation, and model or pricing error.

Promised YTM is the yield if default does not occur. Expected YTM is the probability-weighted average of all possible yields. Default premium is the difference between promised yield and expected yield. Risk premium is the difference between the expected yield on a risky bond and the yield on a risk-free bond of similar maturity.

All bonds have par value $1,000. A risk-free 10-year Treasury STRIPS costs $463.19 (yielding 8%). A risky 10-year zero from XYZ Inc. costs $321.97, promises $1,000, and has an expected payoff of $762.22. From these numbers we can compute the promised YTM, expected YTM, default premium, and risk premium.

The core idea of securitization is that loans can be pooled and repackaged into new claims. Each of those claims is a tranche — a layer that takes losses in a set order. The junior tranches absorb the first losses; the senior tranches take losses only once the junior ones are wiped out. Why securitize? To repack risks to yield more homogeneity within categories, achieve more efficient allocation of risk, create more risk-bearing capacity, provide greater transparency, support economic growth, and extend credit to more borrowers.

But successful securitization requires: diversification, accurate risk measurement, normal market conditions, and reasonably sophisticated investors.

Securitization can reallocate risk. It can create claims that look safer and claims that absorb more risk. But pooling and tranching do not make underlying risk disappear. If the underlying loans are risky, the total pool is still risky. The structure decides who absorbs losses first.

A bank risk manager described holding highly rated AAA and super-senior CDO tranches while trying to eliminate exposure to lower-rated tranches. The logic seemed conservative: keep the supposedly low-risk senior pieces and reduce the risky junior exposure. But during the crisis, senior structured tranches fell in value while some non-investment-grade tranches were squeezed upward. What seemed low-risk under the model became vulnerable once correlation, liquidity, and market stress changed.

A senior tranche may look safe when defaults are assumed to be diversified. But if defaults become correlated, many loans fail together. Then losses can reach the senior tranche. Diversification works when defaults are not all driven by the same shock. When correlation rises, diversification can disappear exactly when it is needed most.

Corporate bonds introduced default risk: the issuer might not pay. Credit ratings and spreads try to summarize that risk. But spreads contain more than expected default loss. Promised yield is not expected yield. Securitization then repackages risky loans into new claims, but the structure depends on diversification, measurement, normal markets, and investor understanding. When correlation and liquidity assumptions break, even senior claims can lose value.