Credit risk

Definition

Credit risk is the possibility that a borrower may default on a loan or fail to meet contractual obligations, leading to a financial loss for the lender or investor. This risk is crucial when considering different types of fixed income securities, as it directly affects the yield and pricing of bonds. Understanding credit risk helps investors make informed decisions about which securities to buy, based on the creditworthiness of issuers and potential returns.

5 Must Know Facts For Your Next Test

1. Credit risk is particularly significant in fixed income investments since bondholders rely on timely interest payments and return of principal at maturity.
2. Credit ratings assigned by agencies like Moody's or S&P play a vital role in assessing credit risk, helping investors gauge the likelihood of default.
3. High-yield bonds, often referred to as junk bonds, carry a higher level of credit risk but typically offer higher yields to compensate investors for that risk.
4. Investors often use credit spreads as an indicator of credit risk; widening spreads suggest increasing perceived risk in the bond market.
5. Active management strategies may focus on adjusting portfolios based on changing assessments of credit risk, while passive strategies typically hold securities regardless of shifting risks.

Review Questions

• How does credit risk impact investment decisions in fixed income securities?
  • Credit risk plays a critical role in investment decisions regarding fixed income securities as it directly influences the yield and price of bonds. Investors assess the creditworthiness of issuers through credit ratings and analyses to determine potential defaults. A higher perceived credit risk may lead investors to demand higher yields, impacting their decisions on which bonds to purchase.
• Discuss how credit ratings are used in evaluating the credit risk of different bonds.
  • Credit ratings serve as an essential tool for evaluating credit risk in bonds, as they provide an assessment of an issuer's ability to meet its debt obligations. Agencies like Moody's and S&P assign ratings based on factors such as financial health and payment history. These ratings help investors understand which bonds are considered safer investments versus those that carry higher risk, guiding them in their purchasing decisions.
• Evaluate the effectiveness of active versus passive management strategies in addressing changes in credit risk within bond portfolios.
  • Active management strategies can be more effective in addressing changes in credit risk as they allow portfolio managers to adjust holdings based on evolving market conditions and credit assessments. This responsiveness can help minimize losses from potential defaults. In contrast, passive management strategies tend to maintain fixed holdings regardless of changing risks, which might expose investors to greater risks if the credit situation deteriorates. The choice between these strategies ultimately depends on an investor's risk tolerance and market outlook.

Related terms

Default Risk: The risk that a borrower will be unable to make the required payments on their debt obligations.

Credit Rating: An assessment of the creditworthiness of a borrower, typically provided by credit rating agencies, which influences borrowing costs.

Yield Spread: The difference in yield between different debt instruments, often used to assess the relative credit risk associated with those instruments.