Corporate bonds: IG vs HY

A corporate bond is a company's IOU: it pays you a fixed coupon on schedule and your principal back at maturity. The rating agencies split the universe in two. Investment Grade (IG) — BBB− and above — are the borrowers deemed solidly likely to pay. High Yield (HY)— BB+ and below, the market's “junk” — are everyone else. That one dividing line drives who owns the bonds, how they trade and, as we'll see, what kind of risk you're actually holding. Everything else in credit — loans, CDS, CLOs — builds on this base case.

Pricing works the same way as any bond: discount the cashflows. But instead of discounting at Treasury rates alone, the market discounts at Treasuries plus a credit spread — the extra yield that prices the chance of default, the chance of a downgrade, and the cost of getting out of an illiquid position. The cleanest measure is the Z-spread: one constant spread added to the whole Treasury curve that reprices the bond to its market quote (Module 4 walks through the mechanics). One refinement matters a lot in HY: most high-yield bonds are callable, and the OAS(option-adjusted spread) is the Z-spread after stripping out the value of that embedded call — the spread you're truly paid for credit.

A useful mental model for where spreads come from:

spread ≈ default probability × (1 − recovery) + risk/liquidity premia

In practice IG trades around 50–150bp over Treasuries, HY around 250–500bp and up, and once the market seriously doubts repayment the bond goes distressed— quoted in points of price rather than spread, because recovery is what's being traded.

What moves the P&L differs sharply across the divide:

• Rates (DV01) — for an IG bond the spread is a small slice of the yield, so Treasury moves dominate the price.
• Spreads (CS01) — the P&L per basis point of spread move; the dominant risk in HY, where spread is most of the yield.
• Default (JTD) — jump-to-default: your loss if the issuer defaults tomorrow. For senior unsecured bonds the classic recovery mark is ~40%, so JTD is roughly 60% of your position.
• Downgrade risk — a BBB− issuer cut to BB+ becomes a “fallen angel,” and IG-only mandates are forced to sell into the downgrade — a price hit before any default.
• Callability — HY issuers refinance when their bonds rally, so prices are capped near the call price: negative convexity.

The takeaway: an IG bond is mostly a rates instrument with a spread kicker; an HY bond is mostly a credit instrument with a rates kicker. As you move down the ratings, CS01 and JTD carry the risk. Build a spread from its parts below and watch the mix flip.