What is Credit Risk?
How does Credit Risk work?
While the definition of credit risk may be straight forward, measuring it is not. Many factors can influence an issuer's credit risk and in varying degrees. Some examples are poor or falling cash flow from operations (which is often needed to make the interest and principal payments), rising interest rates (if the bonds are floating-rate notes, rising interest rates increase the required interest payments), or changes in the nature of the marketplace that adversely affect the issuer (such as a change in technology, an increase in competitors, or regulatory changes). The credit risk associated with foreign bonds also includes the home country's sociopolitical situation and the stability and regulatory practices of its government.
Ratings agencies like Moody's and Standard & Poor's analyze bond offerings in an effort to measure an issuer's credit risk on a particular security. Their results are published as ratings that investors can track and compare with other issuers.
S&P's ratings range from AAA (the most secure) to D, which means the issuer is already in default. Moody's ratings go from Aaa to C. Only bonds rated BBB or better are considered 'investment grade.' Bonds rated below BBB- or Baa3 are considered 'junk.'
Why does Credit Risk matter?
Credit risk is one of the most fundamental types of risk. After all, it represents the chance the investor will lose his or her investment. All bonds, except for those issued by the U.S. government, carry some credit risk. This is one reason corporate bonds almost always have higher coupon payment amounts than government bonds.