Investor Corner/The asset classes/Debt Concepts
2.2.6 Credit Risk / Default Risk
Credit risk, also called default risk, is the possibility that a borrower fails to pay the interest or principal it owes. Higher credit risk is generally compensated with a higher yield.
The risk behind the extra yield
When a corporate bond offers a noticeably higher yield than a government security of similar maturity, that gap exists because the market perceives a real chance the company could struggle to pay. Government securities are generally treated as close to free of default risk, since a government can raise taxes or, in extreme cases, print currency to meet rupee obligations. A private company has no such backstop.
How the market prices this risk
The extra yield a risky borrower must offer over a safer one is called the credit spread. That spread widens during economic stress, when default fears rise across the board, and narrows during calm periods when investors feel more confident lending to weaker borrowers. Watching how credit spreads move is one way analysts gauge the market's collective mood about economic risk.
Managing the risk sensibly
Credit risk is not something to avoid altogether; it is something to be compensated fairly for. The key questions are whether the extra yield on offer genuinely compensates for the added risk, and whether that risk is appropriately sized within the overall portfolio rather than concentrated in a way that a single default could seriously damage.
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