💳 Credit Risk

Learn how borrower defaults can impact investments and lending.

Introduction

Credit risk is the possibility that a borrower will fail to meet their obligations.
It affects lenders, bondholders, and investors who rely on debt instruments for returns.

Core Principles

  • Default Probability: Assess the likelihood of a borrower failing to repay.
  • Credit Ratings: Agencies like Moody’s and S&P provide ratings to gauge risk.
  • Spread Analysis: Higher yields often signal higher credit risk.

How It Works

  1. Evaluate Borrowers: Analyze financial health, cash flow, and debt levels.
  2. Use Credit Ratings: Ratings provide benchmarks for risk assessment.
  3. Diversify Debt Holdings: Spread exposure across issuers and sectors.

Advantages of Understanding Credit Risk

  • Helps investors avoid defaults.
  • Guides portfolio allocation between high‑yield and investment‑grade bonds.
  • Encourages disciplined lending practices.

Risks

  • Default Losses: Borrowers may fail to repay principal or interest.
  • Downgrades: Credit rating cuts can reduce bond values.
  • Concentration Risk: Heavy exposure to one issuer increases vulnerability.

Famous Examples

  • Lehman Brothers (2008): Collapse due to excessive credit exposure.
  • Greek Debt Crisis (2010): Sovereign default risk shook global markets.

Conclusion

Credit risk is central to debt investing.
By understanding borrower health and diversifying exposure, investors can manage potential losses.