What Is Credit Risk?

Credit risk is the probability (risk) that a borrower is going to default on their debt. When you apply for a mortgage, credit card or car loan, your lender will assess the how much of a credit risk you pose – i.e., the likelihood that you won’t pay back your loan.

The interest rate on your loan will depend on the lender’s perception of your credit risk.

Most people are familiar with credit risk from the perspective of a borrower. But – if you want to be a savvy investor – you should also be familiar with credit risk from the perspective of a lender.

When you invest in bonds, you become a lender. A bond is the mechanism through which ordinary people lend money to the government, major companies and other entities.

When people talk about bonds, they often discuss interest rate risk. That’s the risk of market interest rates rising, which generally has the effect of causing bond prices to fall (bad news for bond holders).

But credit risk is another key risk that investors in bonds and other fixed income assets must address.

What Credit Risk Does Your Borrower Pose?

Interest rates are a reflection of the price of credit. That is to say, there are some people who need more money than they have (borrowers) and others who have more than they need (lenders). The prevailing market interest rate is the price at which this supply and demand meet.

But at the nuts-and-bolts level of every transaction, every lender needs to assess the credit risk posed by the borrower. That’s how the lender/borrower arrive upon an interest rate.

If you’re one of those creditors trying to figure out the interest rate that you should charge a borrower, you have to start from some benchmark. Why not start with the least risky thing you can imagine? For practical purposes, that’s US government securities. We often call the rate on US Treasury bonds the “risk-free rate.” That means that if you invest in a Treasury security there should be next-to-no chance that the borrower will default.

(You may argue that Washington gridlock makes a Treasury note at least somewhat risky – and you may be right. But in the absence of anything more compelling, the US government is the closest thing we can find to a risk-free security.)

How Credit Risk Affects Credit Spreads

Let’s say that you want to become a lender, by buying bonds. How can we quantify the credit risk we think the borrower might have?

Let’s say our borrower is a US industrial corporation listed on the S&P 500. There are probably other bond issuers in the market that are also US industrial companies of a similar size, business profile, etc. They may have a bond rating – a designation of their creditworthiness. Maybe there are a few such examples and the average credit rating of all of them is A-, which indicates an investment grade rating.

What are investors paying in the secondary trading market for these bonds? Presumably something close to what we should feel comfortable with in regard to our borrower. If the yield on the nominal 10-year US Treasury note is 2.5% and the A- investment grade corporate bonds are yielding 4.5%, then the the difference between the “risk-free rate” and the rate for the A- company is 2%.

This difference is called a “credit spread.” The spread is the additional premium that you charge the borrower as a result of the credit risk that they pose.

Of course, there may be some important differences between the creditworthiness of one borrower and that of other comparable borrowers in the market. We would adjust the interest rate to reflect those differences. Maybe the sales cycle of our borrower’s products is more volatile than that of the peer group we evaluated. So we may add a bit to that 4.5% benchmark – maybe insisting on 4.6% as the rate at which we would feel comfortable lending.

These decisions happen every day, to the tune of trillions of dollars of bonds trading in global markets. It’s important to understand how credit risk works so you can make more informed decisions when building your own bond portfolio.

How much credit risk is in your portfolio? Tell us what you think.