Credit Risk
What Is Credit Risk?
Credit risk is the possibility that a borrower will fail to repay a loan or meet the financial obligations of a debt security. In investing, credit risk refers to the chance that a bond issuer may default on interest payments or principal repayment.
Credit risk exists in many types of lending and investing.
Why It Matters
Understanding credit risk helps investors and lenders evaluate whether a borrower is likely to repay their obligations. Higher credit risk typically leads to higher interest rates because lenders require greater compensation for the risk they take.
Credit risk plays a central role in bond markets and lending decisions.
How Credit Risk Works
Credit risk is influenced by factors such as:
- the financial strength of the borrower
- credit ratings assigned by rating agencies
- economic conditions
- the borrower’s debt levels
Credit rating agencies assign ratings to bonds to help investors evaluate credit risk.
Example
A bond issued by a financially strong company may have lower credit risk than a bond issued by a struggling company.
Credit Risk vs Interest Rate Risk
- Credit risk refers to the risk of borrower default.
- Interest rate risk refers to changes in bond prices due to interest rate movements.
FAQs About Credit Risk
How do investors measure credit risk?
They often review credit ratings and financial statements.
Why do riskier bonds offer higher yields?
Investors demand compensation for taking on greater risk.
Do government bonds have credit risk?
They typically have very low credit risk.
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