Credit Risk (Default Risk)
Now that you understand capital risk (losing your investment), let's look at a specific cause of capital loss for bond investors: the issuer failing to pay.
What Is Credit Risk?
- Credit risk (also called default risk) is the risk that a bond issuer will fail to make scheduled interest or principal payments
- This is primarily a bond risk; equity investors face different risks (business risk, market risk)
- Higher credit risk = higher yield demanded by investors as compensation
Exam Tip: Gotchas
Credit risk is primarily a bond risk. Expect a distractor applying default risk to equity positions; stockholders face business and market risk, not default risk on coupon payments.
How Is Credit Risk Measured?
- Credit risk is assessed through credit ratings assigned by rating agencies: Moody's, Standard & Poor's (S&P), and Fitch
- Ratings range from highest quality (AAA/Aaa) to default (D)
- Bonds rated BBB-/Baa3 or above are investment grade
- Bonds rated below BBB-/Baa3 are high-yield (junk) bonds
Exam Tip: Gotchas
The dividing line between investment grade and junk is BBB-/Baa3, not BBB+/Baa1. Many institutional investors are restricted to investment-grade bonds only.
Credit Risk by Security Type
| Security | Credit Risk Level | Explanation |
|---|---|---|
| U.S. Treasuries | None | Full faith and credit of U.S. government |
| Agency bonds (Government National Mortgage Association, or GNMA) | None | Explicitly government guaranteed |
| Agency bonds (Fannie Mae/Freddie Mac) | Very low | Implied government backing (not explicit) |
| Investment-grade corporate bonds | Low to moderate | Depends on issuer's financial health |
| Municipal general obligation (GO) bonds | Low to moderate | Backed by taxing power |
| Municipal revenue bonds | Moderate | Backed only by project revenue |
| High-yield (junk) bonds | High | Below investment-grade ratings |
| Exchange-Traded Notes (ETNs) | Depends on issuing bank | Unsecured debt obligation |
Exam Tip: Gotchas
- ETNs carry credit risk because they are unsecured debt of the issuing bank. If the bank goes bankrupt, ETN holders may lose everything.
- Exchange-Traded Funds (ETFs) do NOT carry credit risk of the fund sponsor because ETFs hold actual securities in a trust.
- This ETN vs. ETF distinction is a frequently tested SIE point.
Downgrade Risk
- Downgrade risk is the risk that a rating agency lowers an issuer's credit rating
- A downgrade causes the bond's price to fall (investors demand a higher yield for the now-riskier bond)
- Even if the issuer never actually defaults, the price drop from a downgrade creates a real loss for investors who sell
Exam Tip: Gotchas
Downgrade risk hits the bond's price, not its coupon. Even if the issuer keeps paying, investors who sell after a downgrade realize a real loss.
Credit risk explains why some bonds pay higher yields than others. Next, we'll examine inflation risk, a threat that quietly erodes the value of those very payments.