Credit risk is the chance that the issuer does not pay you what it promised. A missed coupon, a delayed repayment, or a full default. It is the risk that can cost you your principal permanently, and it is priced into every yield you see whether or not you were looking for it.
Credit risk versus interest rate risk
Bonds carry two main risks and they behave completely differently.
Interest rate risk is the chance the market price moves against you because rates changed. The issuer is paying perfectly well. Your bond is just worth less today because newer bonds pay more. Hold to maturity and this costs you nothing in cash terms, because you get every coupon and the full face value. It only bites if you sell early. Why bond prices fall when rates rise covers this one.
Credit risk is the chance the issuer fails to pay. Holding to maturity does not save you, because if the company defaults, the maturity payment is exactly what does not arrive. This is the risk that turns a fixed-income investment into a permanent loss.
One way to hold the distinction: interest rate risk is about when you get paid what you are owed. Credit risk is about whether you get paid at all.
How credit risk shows up in the yield
You never see a line item labelled "credit risk". You see it in the yield.
Take a government bond of a given maturity as the near-riskless benchmark. A corporate bond of the same maturity yields more. That extra amount, the credit spread, is the market's price for the issuer's default risk plus a bit for illiquidity. A AAA issuer trades at a thin spread. A BBB issuer trades wider. A distressed issuer can trade at a spread of many percentage points, which looks like a wonderful yield and is actually the market saying it expects to lose money.
A high yield is almost never a gift. Markets are not charitable. If a bond yields four points more than its peers, the market has priced in something. If you cannot identify what, assume you have not found it yet rather than that it is absent.
The forms credit risk takes
| Form | What happens | Cost to you |
|---|---|---|
| Default | The issuer misses a payment | Can be permanent loss of principal |
| Downgrade | The rating agency lowers its assessment | Price falls; forced institutional selling deepens it |
| Restructuring | Terms are changed: lower coupon, later maturity, partial write-down | A loss against the original promise |
| Recovery risk | Even in default, recovery through insolvency is uncertain and slow | Often well below face value, after years |
A downgrade does not miss a payment, but if you need to sell, it can cost you real money as buyers demand more yield and some holders are forced out under their mandates. Recovery through the insolvency process is a better place to stand if you hold secured senior paper, though it is not a guarantee of getting your money back.
Managing credit risk
Four tools, in rough order of how reliably they work:
- Diversify across issuers. This is the only one that protects you when your judgement about a specific issuer is wrong, which will happen. If no single issuer can cost you more than a small fraction of the portfolio, one default is a setback, not a disaster. Spread across sectors too, because corporate distress often clusters.
- Cap position sizes. Decide in advance the maximum any one issuer can represent, and hold to it even for names you are confident in. Confidence is exactly what precedes the losses that matter.
- Favour higher-rated paper for money you cannot lose. The extra yield on lower-rated bonds is compensation for a real risk. Take that trade only with money you could afford to see impaired.
- Treat unusual yield as a warning. The market's collective view, expressed as a spread, is worth more than a single attractive coupon.
Building a bond ladder helps with interest rate risk but does little for credit risk unless each rung is itself diversified across issuers, a common oversight.
The takeaway
Credit risk is the risk of not being paid back, and it is the one that can permanently cost you principal. It is already priced into every yield as a spread over risk-free rates, so a yield well above peers is information, not opportunity. Diversification across issuers is the defence that works even when you are wrong about a name. Everything else helps only when your analysis holds.