Quick definition Credit risk is the probability that a borrower (or derivatives counterparty) defaults, failing to pay interest, principal, or other obligations. What it is Credit risk applies to bonds, loans, derivatives, and other credit instruments. A bondholder risks that the issuer will default. A bank risks that a loan customer will default. Credit risk is priced into interest rates. A borrower with high credit risk pays higher interest. Why it matters Credit risk is the core source of profit for lenders and bond investors. The interest earned must compensate for default risk. Credit risk management is essential for financial institutions. A large unexpected default can wipe out capital. Credit rating Credit ratings (AAA, AA, A, etc.) are assessments of credit risk. Higher-rated issuers have lower default risk and pay lower rates. Ratings are set by agencies (Moody's, S&P) and can change if issuer fundamentals change. Credit spread The credit spread is the difference between the yield of a risky bond and a safe bond. It compensates for credit risk. Wide spreads indicate high credit risk. Tight spreads indicate low risk. Default probability Credit risk can be quantified as default probability. A bond with 1 percent probability of default is less risky than one with 10 percent probability. Default probability is estimated from historical data, credit ratings, and market pricing. Practical example A company bond yields 5 percent. A treasury bond yields 2 percent. The 3 percent difference is the credit spread, compensating for the risk that the company defaults. If the company's creditworthiness deteriorates (bad earnings, increased debt), the credit spread widens to 5 percent. The bond becomes riskier and the yield increases. See also - Counterparty Risk - Default - Credit Spread - Credit Rating
