Credit Risk

What is “Credit Risk”?

Credit risk is a risk faced by lenders, that a borrower will default or fail to repay their debts. This could be a default on interest payments and/or the principal repayment. In its simplest terms, credit risk simply refers to the likelihood that a company will default on its interest payment and/or principal repayment on bonds.

In the corporate debt markets, the risk of loss from bond defaults is referred to as credit risk. The issuer of a bond generally promises a fixed flow of income to those who invest. Corporate bonds, unlike US Treasury bonds (i.e. government bonds), are not free of credit risk due to the chance that they may be unable to make payments.

Credit Risk – Bonds and Categories of Credit Risk

Corporate bonds usually have higher credit risk than government bonds. This is because the actual payments on these bonds may be less uncertain. The uncertainty is linked to the risk that the company may fail to make the required or contractual payments due to weak financial position, poor cash flow, parlous economic conditions such as a recession (that could result in plunging sales and heavy losses for the firm), money being blocked in long term assets amongst many other factors. In essence, investors in a bond issue have to face credit risk, as they are actually involved in lending money to the issuer.

There are three subcategories of credit risk with reference to bonds.

Default risk: this is the risk that the company that issues the bond will default on its contractual payment obligations. Due to this risk, investors need to be compensated with an incremental return above a government bond (for example, a US Treasury bond).

Downgrade risk: this is a risk that a bond will fall in price because its credit quality deteriorates, which in turn results in the downgrade of a bond issuer’s credit rating. Credit rating agencies such as Standard & Poor, Fitch Ratings and Moody’s assess changes in default risk or the credit quality of a bond and assign a credit rating to it. The rating reflects the credit quality of the bond issue. A bond issue’s credit rating can be upgraded or downgraded at any point. If a bond issue is downgraded, it will likely widen the credit spread and the price of the bond will likely fall.

A high credit rating lowers the cost of borrowing for a bond issuer. AAA (Aaa in the case of Moody’s) is the highest credit rating assigned by the major credit rating agencies. These bonds have the lowest perceived risk of default and have the highest degree of creditworthiness.

Credit spread risk: this refers to the extra or additional yield that is offered by a bond (which is risk-based) over the corresponding risk-free rate offered by a Treasury bond (which is considered risk free) of the same maturity or duration. This ‘extra’ yield is offered to investors as compensation for the relative additional risk that they are undertaking. The risk is that the bond issue might default.

The credit spread may increase or widen if the perception of risk increases for the issuer or the credit fundamentals of the company issuing the bond worsen. As the default risk of a bond issue increases, investors become more risk averse, or the economy witnesses a slowdown or a recession. The risk associated with an increase in credit spread is known as credit spread risk (the increase or widening of credit spreads in turn increases the expected yield of the bond, which leads to a fall in the price of the same).

The yield on a non-treasury or non-government bond (for example, corporate bond) is comprised of the interest rate on a risk-free security (e.g. treasuries at 2%) plus the risk premium (e.g. 1.5%) that is associated with the bond.

Default Risk Premium

The role of a credit rating agency, such as Standard & Poor or Fitch Ratings is to assess the default risk of debt issues of companies – in this example, Company A and Company B. The credit rating reflects the credit quality of the bond issues. Let’s assume that Company A’s bond issue is rated AAA (very high quality investment-grade bond), which reflects high credit quality (i.e. low credit risk), while Company B’s bond issue is rated BB (non-investment grade), which reflects poor credit quality i.e. high credit risk.

In essence, investing in the bond issue of Company B is a more risky investment when compared to Company A, as the chances of default by Company B are perceived to be higher. Consequently, Company B has to offer higher interest rates to potential investors than Company A to compensate for this additional risk. This is shown in the example below – US Treasuries (for example, the 3-month Treasury) are considered as virtually risk-free securities.

Next, let us assume that Company A issues bonds with an annual percentage yield (APY). The rate of return on the corporate bond is 8%, while company B issues bonds with an APY of 12%. Further, we need to take into account the expected inflation rate, as investors do expect that the bonds they invest in will keep up with inflation.

We can assume that the bonds of Company A and Company B both offer a liquidity premium and a maturity premium. Bonds are not always sold easily in the market. Therefore, some bonds offer a liquidity premium to offset this fact. Further, bonds of longer maturities tend to pay higher rates (e.g. 1.5%) than bonds with shorter maturities (for example, 1%). The difference between the two rates (0.5%) is known as maturity premium.

Thus we can calculate the Default Risk Premium:

Default Risk Premium (%) = APY of Corporate Bond (%) – (treasury risk free rate (%) + expected inflation (%) + liquidity premium + maturity premium)

The higher the risk of default, the higher the default risk premium.

The Default Risk Premium for Company A and Company B is calculated in the workout below.