Credit Risk pertains to the possibilities that borrowers might not be able to pay back their loan. This means that the lender would potentially lose its loan principal amount as well as the interest which goes along with it. Such risk occurs as a result of a borrower premise.
The borrowers almost always believe that they will be able to utilize their cash flows from the future in order to pay back their currently agreed upon debts. The reality is that it is practically impossible to guarantee that borrowers will certainly receive those ongoing funds in order to pay back their debts. The reward that issuers receive for taking on such credit risk is the interest payments which borrowers deliver to the issuers of the debt.
Lenders provide credit cards, mortgages, auto loans, and even personal loans to consumers and businesses. Regardless of how strong a candidate may appear on paper, there is always some chance and risk that the borrower will in fact default on the loan obligation. This is much like when a business provides credit to one of its clients. The chances exist that the client may be incapable of paying their invoices to the company.
The phrase credit risk similarly refers to the danger that bond issuers may be unable to deliver their scheduled payments. It could also mean that an insurance company cannot honor a claim on a purchased policy.
The credit risks are figured using the borrower’s total capability of repaying a debt. Assessing credit risks on loans made to consumers involves reviewing and considering what analysts call the “Five C’s.” These are the consumers’ capacity to pay back, their credit history, their collateral, their capital, and their conditions of the loan.
Investors who are contemplating purchasing or investing in a bond also must consider the bond and firm’s underlying credit rating. With a lower rating, the government entity or corporation is in danger of defaulting. It means they have a high risk for default. Alternatively, when such organizations enjoy higher ratings, analysts will call them safer investments.
It is up to the likes of credit risk agencies including Moody’s and Fitch to evaluate the various risks posed by literally thousands of municipalities and corporate bond issuers. They do this continuously in what amounts to an enormous undertaking.
Investors which want to take on a limited amount of credit risk will choose to purchase bonds from municipalities with AAA (triple A) rated credit. When they do not care about some risk in the investment, they could instead pick out a bond that boasts a lesser rating. In compensation for this risk, they will receive potentially more interest in the form of a higher interest rate.
Sometimes there will be a greater perceived risk of default from a bond issuer or borrower. In these cases, investors or lenders would insist on a greater interest rate return for the danger in which they are placing their capital. Examples of this abound. Mortgage applicants who possess fantastic credit ratings as well as a consistent income from a historically stable job will be considered a lower credit risk. This means they will enjoy a better interest rate for their mortgage.
Alternatively, those applicants with poor credit history and scores from the three main credit bureaus will be forced into dealing with a subprime lender. These often predatory types of lenders provide loans with quite high interest rates to those borrowers considered to be higher risk individuals.
The same is true with bond issuers. Those that have ratings which are less perfect will be forced to offer greater interest rates and amounts to investors. The bond issuers in the opposite camp with unblemished credit ratings will enjoy lower rates on their proffered bonds. This is simply because those bond issuers with poorer credit quality will have to engage in offers of higher returns. This is so they can attract investors who would then be taking on a substantial risk of the bonds not being repaid in a timely fashion.