What is credit spread risk and how does it differ from default risk?

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AcadiFi · Accepted Answer

Credit spread risk is the risk that the market-implied spread over the risk-free rate widens, causing mark-to-market losses on bonds and credit derivatives even when the issuer does not actually default. Default risk, by contrast, is the risk that the issuer fails to meet contractual payments. A portfolio manager holding a BBB bond on Meridian Cascade Industries might see the spread widen from 180bps to 320bps during a liquidity stress, producing a 6% price loss, yet the firm continues paying coupons on time. That is pure spread risk. If Meridian Cascade subsequently files for bankruptcy and recovery is 35%, the realized loss from default is separate. Regulators treat them distinctly: spread risk sits in market risk frameworks (IRC, FRTB), while default risk often sits in counterparty or banking book frameworks. Spread risk drivers include changes in risk appetite, liquidity premia, and sector rotation, whereas default risk depends on firm fundamentals like leverage and cash flow. Practically, a long-only credit fund is exposed to both; a CDS protection seller earns premium for bearing both jointly. When you measure capital, you want spread VaR for mark-to-market books and incremental default charges for held-to-maturity exposures. Our FRM Part I credit risk lessons walk through the decomposition with worked examples on synthetic portfolios.

What is credit spread risk and how does it differ from default risk?

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