A bond is a certificate of debt issued by a government or corporation with the promise to pay back the principal amount as well as interest by a specified future date.
But what happens if the government or corporation does not pay back?
When we speak of a credit bond (or loan) we are explicitly recognising the risk that the payments promised by the borrower may not be received by the lender – and event we refer to as default
How does the likelihood of the corporation, the bond issuer, not paying back the bond holder (lender) affect the value of the bond? This is what bond pricing (valuation) in the context of credit risk is about.
The bond’s ‘dirty’ price (including accrued) is the discounted value of probability weighted cashflows. These are in two parts: the promised cashflows, and the recovery in the event of default [ref]Geoff Chaplin. Credit Derivatives: Trading, Investing and Risk Management. Chapters 1.1.1 and 9.3.5[/ref]