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FRM Part I · FRM Exam Part I

Corporate Bonds for FRM Part I: Chapter Guide

Corporate bonds are debt securities issued by firms that pay coupons and principal but carry default risk. For FRM Part I, you must price them using credit spreads, estimate expected loss as PD × LGD × EAD, and read ratings, recovery and liquidity effects. Solve by writing the formula, plugging in numbers, then checking units.

What this chapter covers

This chapter covers debt issued by companies. You start with the contract: coupon, maturity, seniority, security, covenants and embedded options such as calls and conversion. You then see how bonds are issued and how rating agencies sort issuers into investment grade and speculative grade.

The core of the chapter is credit risk measurement. You work with probability of default (PD), recovery rate (RR), loss given default (LGD = 1 − RR) and expected loss (EL = PD × LGD × EAD). You then link these to pricing: a corporate bond's yield equals a benchmark yield plus a credit spread, and that spread compensates for expected loss, risk premium and illiquidity.

The chapter connects to the rest of the paper in several places. Bond pricing and duration come from the valuation topics. Probability and expectation come from quantitative analysis. Credit risk ideas carry into the foundations of risk topic and into Part II credit risk. If you are solid here, many questions on spreads and loss become short calculations.

Corporate bonds sit where quantitative skill meets credit risk, so questions are usually calculation-based and reward clean method. The formulas are short, the traps are predictable, and the ideas reappear in other chapters on credit, markets and valuation. With 100 questions in 4 hours, you have about 2.4 minutes per question, and a drilled expected-loss or spread question can be done well inside that. Time spent here pays back across several topics.

Corporate Bonds: topics in the order to study them

  1. 1Corporate Bond Features and TypesStart with the contract terms, seniority and embedded options, because every later calculation depends on knowing what the bond promises.
  2. 2Bond Issuance and Credit RatingsNext, learn how bonds reach investors and how ratings classify default risk, which sets up the language of credit quality.
  3. 3Default Risk, Recovery Rates and Expected LossThis is the quantitative core, so study it once you know the vocabulary, and practise the PD, LGD and EL formulas until they are automatic.
  4. 4Credit Spreads and Corporate Bond PricingPricing builds on expected loss and discounting, so it comes after default risk is clear.
  5. 5Corporate Bond Markets and LiquidityFinish with market structure and liquidity, which explain why observed spreads exceed pure expected loss.

How to prepare Corporate Bonds

Treat this chapter as a vocabulary layer followed by a short set of formulas. Spend most practice time on calculations, and use the rest to lock in definitions.

  1. Read the features and types material and build a one-page table of seniority ranking, secured versus unsecured, and common embedded options with who benefits from each.
  2. Learn the rating scales at a broad level: investment grade versus speculative grade, and that lower ratings go with higher default rates. Do not memorise specific default statistics.
  3. Write the core formulas from memory: LGD = 1 − RR, EL = PD × LGD × EAD, and approximate spread ≈ PD × LGD for a one-year horizon.
  4. Solve at least ten expected-loss and recovery problems by hand, writing the formula, the numbers and the final answer each time. Include cases with multi-year survival.
  5. Practise pricing a bond by discounting cash flows at a risk-free yield plus spread. Use the financial calculator (N, I/Y, PMT, FV, then CPT PV) and check the answer against a manual sum.
  6. Review liquidity concepts such as bid-ask spreads and thin trading, and be able to explain why they widen spreads beyond expected loss.
  7. Finish with timed mixed sets, and log every error by cause: formula, units, or concept.

Common mistakes in Corporate Bonds

  • Using recovery rate where loss given default is needed

    Fix: Convert first: LGD = 1 − RR. Write LGD on the page before multiplying by anything.

  • Treating the credit spread as pure expected loss

    Fix: Remember it is a simplification. Real spreads also include a risk premium and a liquidity premium, so they are usually wider.

  • Mixing annual and cumulative default probabilities

    Fix: Check the horizon. For constant annual PD, survival over n years is (1 − PD)^n, and cumulative default is one minus that.

  • Getting seniority and option effects the wrong way round

    Fix: Ask who holds the option. The issuer's call lowers the bond's value to investors; the investor's put raises it.

  • Mispricing with the calculator

    Fix: Match N and I/Y to the payment frequency, enter PMT and FV with the same sign, and sanity-check that a higher spread gives a lower price.

  • Memorising rating statistics instead of the logic

    Fix: Focus on direction and relationships: lower ratings mean higher default risk and wider spreads. Use any numbers given in the question.

Last-day revision: Corporate Bonds

  • Corporate bond yield = benchmark yield + credit spread.
  • LGD = 1 − recovery rate.
  • Expected loss = PD × LGD × EAD.
  • Spread compensates for expected loss, risk premium and illiquidity, so it is usually larger than PD × LGD alone.
  • Senior secured debt ranks ahead of senior unsecured, which ranks ahead of subordinated debt, in claims on assets.
  • Callable bonds favour the issuer; putable bonds favour the investor.
  • Investment grade means rated BBB− or higher on the S&P scale (Baa3 on Moody's); below is speculative grade.
  • Higher credit risk means lower price and higher yield, other things equal.
  • Recovery rates are expressed as a percentage of face value.
  • Use annual PD and horizon consistently; do not mix annual and cumulative probabilities.
  • Corporate bonds usually trade over the counter, and liquidity is often poorer than for government bonds.
  • Always check whether a question gives a price, a yield or a spread before choosing a formula.

Corporate Bonds practice questions

Corporate Bonds in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Corporate Bonds: frequently asked questions

How should I calculate expected loss on a corporate bond?

Multiply the probability of default by loss given default and by exposure at default: EL = PD × LGD × EAD. Get LGD from 1 − recovery rate. Check that the PD matches the time horizon in the question.

Is Corporate Bonds a calculation-heavy chapter?

It mixes concepts and short calculations. Expected loss, recovery and spread-based pricing are the numerical parts. Features, ratings and liquidity are mostly conceptual, and you should know them well enough to judge which option is correct.

Do I need to memorise rating agency default tables?

No. Learn the structure of the rating scales and the idea that default risk rises as ratings fall. Questions normally give the numbers you need.

Can I use a financial calculator for bond pricing questions?

Yes, it helps. Enter N, I/Y, PMT and FV, then compute PV, making sure the periods and rate match the coupon frequency. Always practise the manual discounting method too, so you can check your answer.