Credit: The price of doubt

Lending means trusting. And in markets, trust has a rating, a price and clauses.

Let's start with the rating. Agencies rate a borrower's ability to repay.

At the very top, triple A: the lowest risk. Then double A, single A, and triple B.

Down to triple B, it is called investment grade. Below that, speculative grade. And at the very bottom, D: default.

A rating is not a guarantee. It is an opinion, usually paid for by the borrower.

Before two thousand eight, thousands of mortgage securities got a triple A. Many were later downgraded to speculative grade.

Second idea: the spread. It is the rate gap between a borrower and the safest state in its currency.

Say a state borrows at three per cent. A company has to pay four point five per cent.

The gap, one point five points, is the spread. In markets, people say one hundred and fifty basis points.

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On ten thousand euros lent, four hundred and fifty euros a year instead of three hundred. That extra is the price of doubt.

When fear rises, spreads widen all at once. It is often the first sign of a crisis.

Third idea: the covenant. A clause in the contract that protects the lender for the whole life of the loan.

For example: debt must not exceed three times operating profit. Or the company must not sell its factories.

If the clause is breached, the lender can demand repayment immediately. Or renegotiate, to its advantage.

A covenant is an alarm. It goes off before default, while there is still time to act.

And if default happens anyway? The lender does not necessarily lose everything.

The company's assets are sold, and what is left is shared out. The share recovered is called the recovery rate.

Say forty per cent. On a one thousand euro bond, you get back four hundred euros, often years later.

Order matters: lenders secured by an asset come first. Shareholders come last, and often get nothing.

Now let's put it all together. Say a two per cent chance of default a year, and forty per cent recovery.

The expected loss: two per cent times sixty per cent lost. One point two per cent a year.

The spread in the example pays one point five per cent. It covers the expected loss, with a margin for uncertainty.

The twist: a high yield is not a gift. It is almost always the price of a greater risk of default.

Faced with a tempting rate, ask three questions: what rating, what gap with the state, and what do you recover if it goes wrong?