Credit Risk

AAA

DEFINITION of 'Credit Risk'

The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

INVESTOPEDIA EXPLAINS 'Credit Risk'

The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers' overall ability to repay. This calculation includes the borrowers' collateral assets, revenue-generating ability and taxing authority (such as for government and municipal bonds).

Credit risks are a vital component of fixed-income investing, which is why ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and municipalities on an ongoing basis.

VIDEO

Loading the player...
RELATED TERMS
  1. Allowance For Credit Losses

    An estimation of the debt that a company is unlikely to recover. ...
  2. Financing Squeeze

    A situation in which would-be borrowers find it difficult to ...
  3. Credit Cliff

    A slang term referring to the compounding of a company's credit ...
  4. Bond Rating

    A grade given to bonds that indicates their credit quality. Private ...
  5. Settlement Risk

    The risk that one party will fail to deliver the terms of a contract ...
  6. Gross Debt Service Ratio - GDS

    A debt service measure that financial lenders use as a rule of ...
RELATED FAQS
  1. What forms of debt security are available for the average investor?

    Common types of debt securities available to the average investor include U.S. Treasury securities, corporate bonds and municipal ... Read Full Answer >>
  2. In what way is credit risk analysis beneficial when trading in the stock market?

    Some investors use credit risk in analyzing individual stocks to determine whether a company might be in danger of defaulting ... Read Full Answer >>
  3. What is the difference between financial capital and economic capital?

    The word "capital" has many different meanings in economics and finance. Financial capital most commonly refers to assets ... Read Full Answer >>
  4. In what types of financial situations would credit spread risk be applied instead ...

    Default risk and spread risk are the two components of credit risk, which is a type of counterparty risk. Think of default ... Read Full Answer >>
  5. What is liquidity risk?

    Liquidity risk has different meanings in different contexts. In investing terms, bondholders face varying liquidity risks ... Read Full Answer >>
  6. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
Related Articles
  1. Credit & Loans

    Understanding Credit Risk

    Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt.
  2. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  3. Investing Basics

    What Is A Corporate Credit Rating?

    Is the bond you're buying investment grade, or just junk? Find out how to check the score.
  4. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  5. Credit & Loans

    The Importance Of Your Credit Rating

    A great starting point for learning what a credit score is, how it is calculated and why it is so important.
  6. Mutual Funds & ETFs

    ETN Credit Risk May Outweigh Benefits For Some

    Exchange-traded notes have many benefits, but they may not be suited to risk-averse investors.
  7. Insurance

    Basel II Accord To Guard Against Financial Shocks

    Problems with the original accord became evident during the subprime crisis in 2007.
  8. Investing

    Is It Time To Buy Commodities?

    Despite the news, the Athens Stock Exchange is down less than 5 percent year-to-date, while the Shanghai Composite remains up more than 10 percent.
  9. Mutual Funds & ETFs

    ETF Analysis: Energy Select Sector SPDR

    Find out more about the Energy Select Sector SPDR Fund, the top holdings of this exchange-traded fund and the characteristics of the fund.
  10. Mutual Funds & ETFs

    5 Disadvantages of Mutual Funds Compared to ETFs

    In the mutual funds vs. exchange-traded funds debate, ETFs have some clear advantages.

You May Also Like

Hot Definitions
  1. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
  2. OsMA

    An abbreviation for Oscillator - Moving Average. OsMA is used in technical analysis to represent the variance between an ...
  3. Investopedia

    One of the best-known sources of financial information on the internet. Investopedia is a resource for investors, consumers ...
  4. Unfair Claims Practice

    The improper avoidance of a claim by an insurer or an attempt to reduce the size of the claim. By engaging in unfair claims ...
  5. Killer Bees

    An individual or firm that helps a company fend off a takeover attempt. A killer bee uses defensive strategies to keep an ...
  6. Sin Tax

    A state-sponsored tax that is added to products or services that are seen as vices, such as alcohol, tobacco and gambling. ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!