Default Risk vs. Credit Spread Risk

Default risk and spread risk are the two components of credit risk, which is a type of counterparty risk. Think of default risk as more closely associated with the general conception of counterparty risk: noncompliance with the specifications and terms of a contract. Spread risk can be related to investment risk, such as when a price or yield changes as a result of a change in credit rating.

Credit spread risk is not the same thing as the risks associated with a credit spread option, although there are credit spread risks in a credit spread option. Credit spread options are a type of derivative where one party transfers credit risk to another party, usually in exchange for a promise to make cash payments if the credit spread changes. This type of contract is most common among debt securities that have low credit ratings.

Default Risk

Nearly every single loan or credit extension comes with a form of default risk. Default risk is measured by the likelihood an individual or company will not make contractual payments on a debt obligation. Default risk does not exist with financial transactions, for example, stock purchases, that have no guarantee of payment.

For a simple example of default risk, consider a borrower who takes out a $300,000 home loan. The bank that made the loan does not know with certainty whether the borrower will repay the loan on time, so it assumes default risk in the transaction. To compensate for default risk, an interest rate is applied to the loan and the bank may also require a sizable down payment.

Subject to a dispute in utmost good faith by the issuer, payment default represents a failure to pay any amount due of the reference asset or any other future indebtedness of the issuer for funds borrowed, raised or guaranteed. Bonds, loans, credit lines and even cash-on-delivery (COD) purchases all assume a kind of default risk.

Spread Risk

Spread risks are not associated with contractual guarantees but rather originate from the intersection of interest rates, credit ratings and opportunity cost. There are really two types of spread risk, although they are not mutually exclusive.

The first kind, true spread risk, represents the likelihood the market value of a contract or a specific instrument is reduced based on the actions of the counterparty. If the issuer of a bond does not default on its bond obligations, but makes other financial mistakes that lower the issuer's credit rating, the value of the bonds likely drops. This risk is assumed by the investor.

The second type of spread risk comes from credit spreads. Credit spreads are the difference between yields of various debt instruments. The lower the default risk, the lower the required interest rate; higher default risks come with higher interest rates. The opportunity cost of accepting lower default risk, therefore, is higher interest income. Credit spread risk is an important but often ignored component of income investing.

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