What is credit risk? Definition, importance and examples | Arena
What is credit risk? Why is this important?
When an investor buys a bond, they are essentially making a loan to a company or government entity; in return for their investment, the bond issuer agrees to repay the loan (principal) with interest over a specified period. But how can an investor be sure that he will recoup his investment in the first place?
Credit risk, also known as default risk, is a way of measuring the potential for loss from a lender’s ability to repay its loans. Credit risk is used to help investors understand how dangerous an investment is and whether the return offered by the issuer as a reward is worth the risk they are taking.
It is important for investors to understand credit risk so that they can better manage and even mitigate potential losses. In addition, increased regulatory oversight, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, has added transparency to bond investing in recent years, making it even easier for investors to understand what they’re into. embark.
What are some examples of credit risk?
The financial crisis of 2007-2008 highlighted the importance of credit risk management, because in a world as interconnected as ours, few companies are immune to the failures of others. With little oversight in the investment class of mortgage-backed securities, banks had built and traded mountains of toxic debt that imploded when owners of subprime mortgages couldn’t repay their loans. Credit risk management has therefore become an integral component of corporate sustainability.
A few examples of credit risk have been highlighted during the financial crisis:
- Consumers have been unable to repay their home loans. During the financial crisis, these loans were subprime mortgages, whose adjustable rates increased every year.
- Businesses could not pay their bills or insurance obligations and became insolvent. Because homeowners couldn’t repay their loans, subprime mortgage lenders couldn’t generate the capital they needed to fund their operations, and so they went bankrupt.
- Bond issuers, such as investment banks, could not repay their debt and became insolvent. Assets that backed pools of mortgage-backed securities, known as guaranteed mortgage bonds (CMOs), became worthless, causing a series of dominoes to fall, leading to the collapse of global entities like Lehman Brothers.
- Banks were unable to return funds to depositors and experienced a credit crunch. Many were on the verge of failure, and the US government had to step in with emergency funding and other forms of liquidity, such as lowering interest rates and implementing quantitative easing measures. .
How is credit risk calculated?
The job of credit rating agencies, such as Standard & Poor’s, Fitch Ratings and Moody’s, is to quantify the amount of credit risk associated with bonds. Using statistical analysis, they assess creditworthiness by analyzing various factors, such as:
- Assets under management
- Likely return on investment
- Restrictive covenants
The rating agencies then issue an alphabetical rating. AAA is the highest: This means that the issuer is extremely capable of meeting its financial commitments. The lowest rating, D, means the issuer is currently in default.
US Treasury securities are rated AAA. They are considered free from credit risk because they are backed by the power of the US government to collect taxes and meet its financial obligations.
All other types of bonds carry some credit risk. Bonds with a rating of BB+ and below are known as high yield or junk bonds, which offer higher yields to compensate for their increased levels of risk.
It is also important to note that bond ratings may change over time. As we saw during the financial crisis, over 75% of CMOs were downgraded to junk status, resulting in over half a trillion dollars in losses.
What are the other risks associated with bond investing?
In addition to credit risk, both fixed income and bond investors should always have strategies in mind to deal with market unpredictability. Other risks they need to watch out for include:
Interest rate risk
Interest rate risk is the risk that the value of a bond will decline if interest rates rise. Longer-term bonds are more sensitive to interest rate risk because interest rates are very likely to rise over a period of 30 years, which is the typical maturity of a long-term bond. Therefore, bonds with longer maturities generally offer the highest yields, although they are also the most volatile.
Inflation risk is the decline in the value of a bond due to a prolonged period of rising prices. Rapid inflation is never a good thing, which is why the Federal Reserve monitors it so carefully and adjusts the federal funds rate when it feels it has risen too much or too quickly.
Call risk occurs when a bond issuer redeems or calls a bond before it reaches maturity. Although the bondholder always receives a payment on the value of the bond, he often has to reinvest his proceeds in a low-yielding environment.
How to manage credit risk?
Every investment involves risk. However, there are ways for bond investors to manage or even reduce their credit risk by diversifying their portfolios. For example, they could buy bonds with investment grade ratings, such as US government bonds, like EE bonds: their face value is guaranteed to double in 20 years. Bond investors should also be aware of prevailing interest rates, which affect the value of their investments, and stick to bonds with short to medium-term issues. Owning bonds with different maturities also helps to add diversification.
Bond investors could also benefit from hedging instruments to protect their portfolios. TheStreet guest contributor Jay Pestrichelli believes in a particular “buy and hedge” strategy.