Glossary
Credit Risk
The risk that a borrower fails to make promised interest or principal payments in full and on time.
Credit risk is the chance that whoever owes you money does not pay it back as promised. For a bond investor it covers outright Default, late or partial payment, and the milder but more common case in which the borrower's finances weaken, its rating is cut and the bond's price falls even though every coupon still arrives.
How it is measured
Investors size credit risk in three main ways:
- Ratings. Agencies such as S&P, Moody's and Fitch grade issuers from AAA down to D. Anything at BBB-/Baa3 or above is Investment grade; lower grades are high yield. See Credit rating.
- Market prices. The Credit Spread over Treasuries, and the cost of protection in the Credit Default Swap (CDS) market, show what lenders are charging for the risk right now.
- Financial ratios. Leverage measures such as Debt-to-Equity Ratio and the ability to service debt, captured by Interest coverage ratio, show how much cushion the borrower has.
Expected loss
Where it shows up
Credit risk is not only a bond concern. A bank deposit above insured limits, a brokerage counterparty, a supplier owed money and a company's own customers paying on credit all carry it. US Treasuries are treated as close to free of credit risk, which is why their yields serve as the Risk-free rate that others are priced against. Credit risk also tends to cluster: defaults rise together in recessions, so a diversified bond fund can still see losses spike at once.