Credit risk

In any payment, there are two parties where one party owes money to the other party. When the payment is not immediate but is supposed to happen in the future, there is a contractual agreement between the two parties. The borrower is supposed to fulfill its payment obligation at some time in the future. The lender being the counterparty faces a risk, that the borrower may not be in a suitable position to return its money back or pay the periodic future interest payments for a variety of reasons. This risk faced by the lender, that the borrower may fail to keep its promise of payment in the future is called Credit Risk.

Credit risk can arise in case of banks disbursing loans or issuing credit cards to its customers. The bank faces the credit risk of its customers failing to make timely loan or credit card payments. Similarly, in case of a bond, the bond issuer has promised to pay the bond investors a fixed or floating interest rate periodically and return their principal when the bonds mature. The bond investors (bond buyers or lenders) face a credit risk that the entity that issued them the bonds may fail to make these payments in future.

Credit risk in case of bond investments can arise due to many factors. The bond issuer may be undergoing a financial crisis due to unfavourable business environment resulting in low profitability or poor business growth. In such a scenario, the bond issuer may not be able to meet its payment obligations of periodic interest or repayment of principal to its bond holders at maturity. Credit risk can also arise when the bond issuer has borrowed money from banks in the form of loans and has to prioritize those payments over payments to its bond holders. Thus, credit risk arises in situations where a bond issuer is not in a sound financial situation to be able to fulfil its payment obligations on the bonds issued by it to investors.

A credit risk can end up in default by the bond issuer subsequently. In case of a default by the bond issuer, the bond issuer fails to either make the periodic coupon (interest) payments or repay the principal invested by bond holders at the time of maturity. Thus, investors must evaluate the credit worthiness of bond issuers before buying their bonds. For instance, debt Mutual Funds investing their pool of investor money in debt instruments must carefully evaluate the credit worthiness of a bond before including it in the fund’s portfolio i.e. before buying such a bond.

You can evaluate the credit worthiness of a bond issuer by looking at the credit rating assigned to its bonds by a reputable credit rating agency. The credit rating is assigned to bond issuers after complete analysis of their financials that includes

• Balance sheet
• Cash flows and profitability
• Ability to pay future debt (borrowing) obligations
• Past record in fulfilling debt obligations