Credit risk

An investor’s risk of loss arising from a deterioration in the credit quality of a borrower, and/or a borrower’s failure to pay loans as promised. Such an event is called a default. The lender or investor loses the principal (amount lent) and interest.

Investors are compensated for assuming credit risk via the return, or yield they receive for lending their capital. Thus credit risk is closely tied to the potential return of a credit investment; yields on bonds correlate strongly to their perceived credit risk. The higher the perceived credit risk, the higher the yield or interest rate that investors will require for lending their capital.

If an issuer’s credit risk goes up (credit rating deteriorates), its price declines and yield rises due to the inverse price-yield relationship. Therefore after the downgrade, new bonds issued by the same issuer will have a higher yield, as the market now requires a greater yield to compensate for the higher risk of default. The investor, having purchased the security before the downgrade has locked in a yield of 4% and therefore faces unfavourable conditions. The opposite is true in the case of an improvement in credit conditions.

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