Home ETFs What Is Credit Risk? Definition, Importance & Examples

What Is Credit Risk? Definition, Importance & Examples

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What Is Credit Risk? Definition, Importance & Examples


Credit risk deals with losses due to a lender’s ability to repay the loan.

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What is credit risk? Why is it so important?

When investors buy bonds, they are essentially making a loan to a company or government entity; in return for their investment, the bond issuer promises to repay the loan (principal) and interest over a period of time. But how can investors be sure they’ll get their money back in the first place?

Credit risk, also known as default risk, is a measure of potential losses due to a lender’s ability to repay a loan. Credit risk is used to help investors understand how risky an investment is — and whether the benefits the issuer offers in return are worth the risk they take.

It is important for investors to understand credit risk so they can better manage and even mitigate potential losses. Additionally, increased regulation, such as the Dodd-Frank Wall Street reform and consumer protection laws, has increased transparency in bond investing in recent years, making it easier for investors to see exactly where they are investing.

What are some examples of credit risk?

The financial crisis of 2007-2008 highlighted the importance of credit risk management – ​​because in an interconnected world like ours, few businesses are immune to the failure of others. With little oversight over the investment class of mortgage-backed securities, banks have built and traded large amounts of toxic debt that collapsed when subprime mortgage owners couldn’t repay their loans. Therefore, credit risk management has become an indispensable part of the sustainable development of enterprises.

Some examples of credit risk were highlighted during the financial crisis:

Consumers are unable to repay their home loans. During the financial crisis, these loans were subprime mortgages characterized by adjustable interest rates that rose every year. The business is unable to pay its bills or policy obligations and becomes insolvent. With homeowners unable to repay their loans, subprime lenders couldn’t generate the funds they needed to operate, and they went bankrupt. Bond issuers, such as investment banks, cannot pay their debts and become insolvent. The assets that backed the pool of mortgage-backed securities, known as collateralized mortgage bonds (CMOs), became worthless, leading to a string of dominoes that collapsed and led to the collapse of global entities such as Lehman Brothers. Banks were unable to return funds to depositors and experienced a credit crunch. Many were teetering on the brink of failure, and the U.S. government had to step in for emergency funding and other forms of liquidity, such as lower interest rates and quantitative easing.

How is credit risk calculated?

The job of credit rating agencies such as Standard & Poor’s, Fitch Ratings and Moody’s is to quantify the amount of credit risk associated with bonds. Using statistical analysis, they evaluate reputation by analyzing various factors, such as:

Managed Assets Insurance Potential Return on Investment Debt Covenant

Rating agencies then issue letter grade ratings. Highest AAA: This means the issuer is extremely capable of meeting its financial commitments. The lowest grade of D indicates that the issuer is currently in default.

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street dictionary term

Bond Rating Investment Grade

AAA

extremely strong

AA

very strong

One

strong

BBB

enough

BB

Facing significant uncertainty, but less vulnerable in the near term

Second

More vulnerable to adverse business impacts in the short term in the face of significant uncertainty

CCC

vulnerable

cc

Highly vulnerable to non-payment

C

A default has yet to happen, although that’s to be expected

D

Payment default or bankruptcy

U.S. Treasuries are rated AAA. They are considered to have no credit risk because they are backed by the U.S. government’s power to collect taxes and meet its financial obligations.

All other types of bonds carry some credit risk. Bonds rated BB+ and below are known as high-yield or junk bonds, and they offer higher yields to compensate for their increased level of risk.

Generally, the more credit risk a bond carries, the higher its yield.

It’s also important to note that bond ratings can change over time. As we saw during the financial crisis, over 75% of CMOs were downgraded to junk status, with a combined loss of over $5 trillion.

What other risks are there in bond investing?

In addition to credit risk, fixed income investors such as bond investors should always keep in mind strategies for dealing with market unpredictability. Other risks they should be aware of include:

Interest Rate Risk

Interest rate risk is the risk that a bond’s value will fall when interest rates rise. Long-term bonds are more susceptible to interest rate risk, as interest rates are likely to rise over a 30-year time frame, the typical maturity date for long-term bonds. As a result, long-term bonds typically offer the highest yields — even though they are also the most volatile.

inflation risk

Inflation risk is the decline in the value of bonds as prices continue to rise. Rapid inflation is never a good thing — that’s why the Fed monitors it so carefully and adjusts the federal funds rate when it thinks it’s rising too much or too fast.

call risk

Redemption risk is when the bond issuer redeems or redeems the bond before the bond matures. While bondholders still receive payment for the value of the bond, they often have to reinvest their earnings in a low-yield environment.

How to manage credit risk?

Every investment has risks. However, bond investors can manage and even reduce their credit risk by diversifying their portfolios. For example, they can buy bonds with investment grade ratings, such as US government bonds, such as EE bonds: their face value is guaranteed to double in 20 years. Bond investors should also pay attention to the prevailing interest rates that affect the value of their investments, and stick to short- to medium-term bonds. Having bonds with different maturities also helps increase diversification.

Bond investors can also benefit from hedging tools to protect their portfolios. Jay Pestrichelli, a guest writer for TheStreet, believes in a special “buy and hedge” strategy.

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