Bartolome Ozonas for iStockphoto; Canva
What Is Credit Risk? Why Is It Important?
When an investor purchases a bond, they are essentially making a loan to a corporation or government entity; in return for their investment, the bond issuer promises to repay the loan (principal) with interest over a period of time. But how can an investor be sure that they will recoup their investment in the first place?
Credit risk, also known as default risk, is a way to measure the potential for losses that stem from a lender’s ability to repay their loans. Credit risk is used to help investors understand how hazardous an investment is—and if the yield the issuer is offering as a reward is worth the risk they are taking.
It is important for investors to understand credit risk so that they can better manage—and even mitigate—potential losses. In addition, enhanced regulatory oversight, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, has added transparency into bond investments in recent years, making it even easier for investors to understand exactly what they’re getting into.
What Are Some Examples of Credit Risk?
The Financial Crisis of 2007–2008 highlighted the importance of credit risk management—because in a world as interconnected as ours, few businesses are immune from another’s failures. With little oversight into the investment class of mortgage-backed securities, banks had built and traded mountains of toxic debt that imploded when subprime mortgage owners could not make payments on their loans. Credit risk management, therefore, has become an integral component of corporate sustainability.
A few examples of credit risk were highlighted during the Financial Crisis:
- Consumers were unable to make payments on their home loans. During the Financial Crisis, these loans were subprime mortgages, which featured adjustable rates that jumped higher every year.
- Businesses could not pay their bills or policy obligations and became insolvent. Because homeowners could not repay their loans, subprime mortgage lenders could not generate the capital they needed to fund their operations, and so they went bankrupt.
- Bond issuers, such as investment banks, could not make payments on their debt and became insolvent. The assets that backed pools of mortgage-backed securities, known as collateralized mortgage obligations (CMOs), became worthless, causing a string of dominoes to fall, which resulted in the collapse of global entities like Lehman Brothers.
- Banks were unable to return funds to depositors and experienced a credit crunch. Many teetered on the brink of failure, and the U.S. government had to step in with emergency funding and other forms of liquidity, such as lowering interest rates and undertaking quantitative easing measures.
How Is Credit Risk Calculated?
The job of credit ratings agencies, like Standard & Poor’s, Fitch Ratings, and Moody’s, is to quantify the amount of credit risk associated with bonds. Using statistical analysis, they assess creditworthiness by analyzing a variety of factors, such as:
- Assets under management
- Insurance
- Likely return on investment
- Debt covenants
The ratings agencies then issue a letter-grade rating. AAA is the highest: It means the issuer is extremely capable of meeting its financial commitments. The lowest grade, D, means the issuer is currently in default.
U.S. Treasury Securities carry the AAA rating. They are considered free of credit risk since they are backed by the power of the U.S. government to collect taxes and meet its financial obligations.
All other types of bonds entail some credit risk. Bonds with a rating of BB+ and lower are known as high-yield or junk bonds, which offer higher yields to compensate for their increased levels of risk.
It’s also important to note that bond ratings can change over time. As we saw during the Financial Crisis, more than 75% of CMOs were downgraded to junk status, which added up to more than half a trillion dollars in losses.
What Are Some Other Risks in Bond Investing?
In addition to credit risk, fixed-income investors like bond investors should always have strategies in mind to deal with market unpredictability. Other risks they should watch out for include:
Interest Rate Risk
Interest-rate risk is the risk of a bond’s value decreasing if interest rates rise. Longer-term bonds are more susceptible to interest rate risk because it’s very likely that interest rates will rise over a 30-year timeframe, which is the typical maturity of a long-term bond. Therefore, bonds with long maturities typically offer the highest yields—although they also have the most volatility.
Inflation Risk
Inflation risk is the decline in the value of a bond due to a sustained period of rising prices. Rapid inflation is never a good thing—that’s why the Federal Reserve monitors it so carefully and adjusts the Fed Funds Rate when it believes it has risen too much or too quickly.
Call Risk
Call risk is when a bond issuer redeems, or calls, a bond before it reaches maturity. While the bondholder still receives payment on the value of the bond, they often have to reinvest their proceeds in a lower-yield environment.
How Can Credit Risk Be Managed?
Every investment has risks. However, there are ways bond investors can manage or even reduce their credit risk by diversifying their portfolios. For example, they could purchase bonds with investment-grade ratings, such as U.S. government bonds, like EE Bonds: Their face value is guaranteed to double in 20 years. Bond investors should also be mindful of prevailing interest rates, which affect the value of their investments—and stick with bonds with low- to intermediate-term issues. Owning bonds with different maturities also helps to add diversification.
Bond investors could also benefit from hedging instruments to safeguard their portfolios. TheStreet’s guest contributor, Jay Pestrichelli, believes in a particular “buy and hedge” strategy.
