Credit Risk

Credit risk is the risk of financial loss arising from a borrower's or issuer's failure to meet the terms of a debt. It is the genus that contains default risk as its most severe case. A bond investor bears credit risk in three related forms: the issuer may default outright, the issuer may be downgraded so that the bond is judged riskier, or the market may simply demand a higher yield for the issuer's debt, which pushes the existing bond's price down. All three reduce the value of what the investor holds, and only the first involves an actual missed payment, which is why credit risk is broader than default alone.

It is tempting to treat credit risk and default risk as the same thing, but the distinction is where the concept earns its keep. Default risk is the specific chance that an issuer actually fails to pay. Credit risk is the wider category that also includes two things short of default: a rating downgrade, which signals deterioration and often forces some holders to sell, and a widening of the credit spread, the gap between the bond's yield and that of a comparable Treasury. A bond can lose value from either of those even though every coupon has been paid on schedule. The market prices credit risk directly. A risky issuer must offer a higher yield than the U.S. Treasury to persuade investors to lend, and that difference is the credit spread. When the economy weakens or a particular issuer stumbles, spreads widen, existing bonds fall in price, and the compensation demanded for new lending rises. Credit ratings from Moody's, S&P, and Fitch are the standard shorthand for an issuer's credit risk, though they are opinions rather than guarantees. The most reliable defense against credit risk is diversification across many issuers, usually through a bond fund, so that any single issuer's trouble is a small part of the whole. This is different from interest-rate risk, which is the risk that changing rates move a bond's price regardless of the issuer's health; a Treasury bond has essentially no credit risk but plenty of interest-rate risk.

Credit risk shows up as the yield spread a riskier bond pays over a Treasury, and that spread moves as perceptions of the issuer change.

A hypothetical example. Two five-year bonds trade in the market.

• A Treasury note yields 4 percent, taken as having essentially no credit risk.
• A corporate bond from a mid-quality issuer yields 5.5 percent.
• The 1.5 percentage-point (150 basis-point) difference is the credit spread, the market's price for that issuer's credit risk.

Suppose the issuer is later downgraded. Investors now demand a wider spread, say 2.5 percentage points, so the corporate bond's price falls to lift its yield toward 6.5 percent, even though the company has not missed a single payment. The holder has lost money to credit risk without any default having occurred, which is exactly the point that separates credit risk from the narrower default risk.

Pros (of accepting measured credit risk)

• Bonds with more credit risk pay higher yields, so accepting measured credit risk is a way to earn more income than Treasuries provide.
• It can be diversified away to a large degree by holding many issuers, so the reward can be captured while the issuer-specific danger is diluted.

Cons

• Credit risk can hurt you without a default, through downgrades and widening spreads that lower prices.
• It tends to bite hardest in recessions, exactly when other parts of a portfolio are also under stress.
• Ratings, the usual gauge, are opinions that can lag reality, so they are a starting point rather than a guarantee.