Credit risk
What is Credit risk?
Credit risk is the risk of financial loss when a borrower, bond issuer, or contractual counterparty cannot or will not meet its obligations as agreed.
Why credit risk matters
Credit risk affects bonds, loans, deposits, derivatives, securities lending, and other contractual claims. Loss can arise from default, restructuring, delayed payment, or a decline in perceived credit quality before default occurs. Because promised upside is usually limited while losses can be large, disciplined underwriting, diversification, seniority analysis, and recovery assumptions are central to credit investing.
How it is assessed
Analysis considers probability of default, exposure at default, loss given default, expected loss, credit rating, spread, leverage, cash flow, collateral, covenants, maturity, and seniority. Market prices provide timely but noisy information through spreads. Fundamental analysis tests whether the borrower can service debt under realistic and stressed operating conditions.
Example
A five-year corporate bond may offer a higher yield than a government bond because investors require compensation for expected default loss, uncertainty, liquidity, and other risks. If the issuer's earnings weaken, its spread may widen and the bond price may fall even while payments continue. Default could later produce a partial recovery rather than a total loss.
How to interpret it
A high yield is not itself evidence of attractive compensation. Compare spread and expected return with default probability, recovery, liquidity, optionality, and exposure to the economic cycle. Aggregate related issuers and industries, since separate legal entities can depend on the same cash flows. Examine migration risk as well as the binary outcome of default.
Limitations
Ratings and models can respond slowly to changing conditions, financial statements may not capture contingent liabilities, and recovery values are uncertain. Correlations among defaults tend to increase during recessions. Credit derivatives may transfer part of the exposure while adding counterparty and basis risk. Historical default averages should not be applied mechanically to a specific issuer or cycle.
Practical checklist
Identify the legal borrower, payment priority, guarantees, collateral, covenants, maturity schedule, currency, and refinancing needs. Model cash flows under downside assumptions and estimate recovery by claim seniority. Monitor spreads, ratings, earnings, liquidity, and covenant headroom. Set issuer and sector limits using direct and look-through exposures, and distinguish expected credit loss from unexpected stress loss.
Also known as: default risk