FRM Exam Part I · Corporate Bonds

Bond Issuance and Credit Ratings for FRM Part I

Updated 11 October 2026 · Fact-checked

A corporate bond is issued in the primary market when an issuer, helped by underwriters, sells new bonds to investors. Rating agencies then grade default risk on a letter scale. BBB-/Baa3 and above is investment grade; BB+/Ba1 and below is high yield. Lower ratings mean higher default risk and wider credit spreads.

Understand Bond Issuance and Credit Ratings

A company that needs funds can borrow from a bank or sell bonds to investors. When it sells new bonds, this is the primary market. The issuer hires one or more underwriters (investment banks). They advise on size, maturity, coupon and covenants, prepare the offering documents, and market the bond to investors. The issuer receives the sale price less the underwriting fee.

Issuance can be done in different ways. In a public offering, the bond is registered with the regulator and sold widely. In a private placement, bonds are sold to a small group of institutions with lighter disclosure rules and less liquidity. In a firm commitment underwriting, the underwriters buy the whole issue and bear the risk of not reselling it. In a best efforts deal, they only try to sell it. Bonds are often priced off a government benchmark plus a credit spread. Once issued, trading happens in the secondary market.

Investors cannot analyse every issuer, so rating agencies such as S&P, Moody's and Fitch give an opinion on the issuer's ability to pay. S&P and Fitch use AAA, AA, A, BBB, BB, B, CCC, CC, C and D, with + and - modifiers. Moody's uses Aaa, Aa, A, Baa, Ba, B, Caa, Ca and C, with numeric modifiers 1, 2, 3. The key dividing line is between investment grade (BBB-/Baa3 or better) and high yield, also called speculative grade or junk (BB+/Ba1 or worse).

Ratings matter for pricing. Lower-rated bonds have higher probabilities of default, so investors demand a higher yield. The credit spread widens as the rating falls, and it widens sharply at the lower grades. A downgrade usually pushes the price down. A downgrade across the investment-grade boundary (a fallen angel) can force sales, because many institutions are restricted to investment-grade holdings.

A rating transition matrix shows the probability that a bond rated X at the start of a period has rating Y at the end, including default. Each row sums to 100%. Rows for high ratings have large diagonal values, meaning most bonds keep their rating. Default is an absorbing state: once a bond defaults, it stays there. Cumulative default rates rise with horizon and are higher for lower ratings.

Key formulas to remember

Credit spread: Credit spread = Corporate bond yield − Benchmark government yield (same maturity); Compensation for default risk, and often liquidity risk, relative to a risk-free bond.
Investment grade boundary: Investment grade: BBB-/Baa3 or higher. High yield: BB+/Ba1 or lower; Memorise both S&P/Fitch and Moody's notation. Moody's Baa3 corresponds to BBB-.
Transition matrix row rule: Σ over j of P(i → j) = 100% for each starting rating i; Includes the default column. Use it to find a missing entry in a row.
Multi-period transition: Two-year matrix = One-year matrix × One-year matrix; Assumes the transitions are time-homogeneous (Markov). For a single entry, multiply row i by column j.
Survival probability: Survival over n years = 1 − Cumulative default probability over n years; Also, with constant annual default probability p: survival = (1 − p)^n.
Approximate spread and loss link: Credit spread ≈ PD × LGD (annual, under simple assumptions); LGD = 1 − recovery rate. A rough link, ignoring risk premium and liquidity.

How to solve Bond Issuance and Credit Ratings questions

Questions in this topic are either conceptual (rating scales, issuance methods) or numeric (transition matrices, spreads). Use this sequence.

1Identify the type of question: issuance process, rating classification, pricing effect, or transition matrix calculation.
2For classification, convert the rating to a common ladder. Place BBB-/Baa3 as the last investment-grade notch.
3For issuance, decide who bears risk: firm commitment means the underwriter, best efforts means the issuer. Public means registered, private means restricted and less liquid.
4For pricing, link rating to default probability, then to the required spread. Lower rating means wider spread and lower price, other things equal.
5For a transition matrix, read the correct row (starting rating) and column (ending rating). Check that the row sums to 100%.
6For multi-year probabilities, multiply along each path and add the paths that end in the target state. Or multiply the matrices.
7Check the answer: probabilities between 0 and 1, rows sum to 100%, and default probability rises as the rating falls.

Quickest way: Path-sum shortcut for a two-year transition

When to use it: When asked for the probability of moving from rating A to rating C (or default) over two years using a one-year matrix.

Write the starting row for A.
List each possible intermediate rating after year one with its probability.
For each, multiply by the probability of going from that intermediate rating to the target in year two.
Add the products. Only paths that matter need to be computed.
If the target is default, remember default is absorbing: a bond already in default contributes its year-one default probability × 100%.

Common mistakes in Bond Issuance and Credit Ratings

Treating BB+/Ba1 as investment grade.
Students remember that BB is 'close' to BBB, or confuse the notch boundary.
Fix: The last investment-grade notch is BBB-/Baa3. Anything at BB+/Ba1 or below is high yield.
Mixing up S&P and Moody's labels, such as saying Baa is speculative.
Moody's uses different letters, and Baa looks lower than BBB.
Fix: Baa1, Baa2, Baa3 equal BBB+, BBB, BBB-. Ba1 equals BB+.
Forgetting the default column when checking that a transition row sums to 100%.
Tables often show default on the far right and students stop at the last rating.
Fix: Always include default (D). The missing entry equals 100% minus the sum of all other entries in the row.
Squaring only the diagonal entries to get a two-year transition.
Students ignore the paths through other ratings.
Fix: Sum over all intermediate states. Squaring the diagonal captures only the path that stays unchanged both years.
Confusing firm commitment with best efforts underwriting.
Both involve an underwriter, so the risk allocation is overlooked.
Fix: Firm commitment: the underwriter buys the issue and carries the unsold risk. Best efforts: the underwriter acts as an agent and the issuer keeps the risk.
Assuming a rating change is the same as a default.
A downgrade sounds like a failure.
Fix: A downgrade is a change in credit quality. Default is a separate state. Most downgrades do not end in default within one year.

Worked examples

Example 1

A one-year transition matrix gives the following for a bond rated BBB: to A 5%, to BBB 86%, to BB 6%, to B 1%, to default 0.2%, and to all other ratings combined 1.8%. What is the probability the BBB bond is still investment grade at year end, assuming BBB means BBB (the lowest notch is ignored) and that A and BBB are the only investment-grade states shown, with the 'other' group being non-investment grade?

Show the solution

Check the row: 5 + 86 + 6 + 1 + 0.2 + 1.8 = 100%. The row is complete.
Investment-grade end states: A (5%) and BBB (86%).
Add them: 5% + 86% = 91%.

Answer: 91%

Example 2

A one-year matrix shows: from A, 90% stay A, 8% move to B, 2% default. From B, 70% stay B, 20% move to A, 10% default. Default is absorbing. What is the two-year cumulative default probability for a bond starting at A?

Show the solution

Year one: A with probability 0.90, B with 0.08, default with 0.02.
Paths to default by the end of year two: default in year one, A then default, B then default.
Default in year one: 0.02.
Stay A, then default: 0.90 × 0.02 = 0.018.
Move to B, then default: 0.08 × 0.10 = 0.008.
Sum: 0.02 + 0.018 + 0.008 = 0.046.

Answer: 4.6%

Exam tips

Memorise the investment-grade line on both scales. It is the most frequently tested fact in rating questions.
In transition matrix questions, check which row you start in. Rows are the starting rating, columns are the ending rating.
Use the row-sum-to-100% check to find a missing entry before doing anything else.
For multi-year default probabilities, list the paths on paper. It is faster and safer than full matrix multiplication.
Link every conceptual answer back to default probability, spread and price. Lower rating, higher spread, lower price.

Practice questions from Corporate Bonds

Bond Issuance and Credit Ratings in other exams

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

Bond Issuance and Credit Ratings: frequently asked questions

What is the difference between investment grade and high yield?

Investment grade bonds are rated BBB-/Baa3 or higher and have lower default risk. High yield bonds are rated BB+/Ba1 or lower and carry higher default risk, so they pay higher yields. Some institutions can only hold investment-grade bonds.

How are corporate bonds issued in the primary market?

The issuer hires underwriters, who help set terms, prepare documents and sell the bonds to investors. The issue can be a public offering or a private placement. Underwriting is either firm commitment, where the underwriter takes the risk, or best efforts.

How do I read a rating transition matrix?

Each row is a starting rating and each column is an ending rating after a period, usually one year. The entries are probabilities and each row sums to 100%. Default is the last column and is an absorbing state.

Does a lower rating always mean a wider spread?

Generally yes, because investors demand more compensation for higher default risk. But spreads also reflect liquidity, market conditions and recovery expectations. So the link is strong on average, not exact for every bond.