Credit risk, is inherent in any financial transaction between two parties that gives one party a future obligation to the other. The risk is that the first party will fail to meet that obligation. This failure to meet financial obligations includes default, but it could also include any waiver, deferral, re-scheduling or adjustment to the terms of the obligation that is unfavorable to the creditor.
Any company that makes a sale to a customer with terms involving future payment takes some degree of credit risk to that customer, and that exposure is often longer term than initially thought.
Credit risk can also refer to the credit risk inherent in derivative transactions. This level of risk will depend on the creditworthiness of the counterparty, the term of the contract and the nature of the contract. However, Whatever the terms of the contract, the potential credit exposure inherent in a derivative transaction is only a fraction of the notional amount of that transaction.
Types of Credit Risk
The types of credit risk are as follows:
1. Default Risk: It is the possibility that a bond issuer will default, by failing to repay principal and interest in a timely manner. Bonds issued by the federal government, for the most part, are immune from default. Bonds issued by corporations are more likely to be defaulted on, since companies often go bankrupt. Municipalities occasionally default as well, although it is much less common.
2. Credit Spread Risk: The difference between the yield on a corporate bond and a government bond is called the credit spread. As such, the credit spread reflects the extra compensation investors receive for bearing credit risk. So, that total yield on a corporate bond is a function of both the treasury yield and the credit spread, which is greater for lower-rated bonds. If the bonds is callable by the issuing corporation, the credit spread increases more, reflecting the added risk that the bond may be called.
3. Downgrade Risk: Downgrade risk is the risk that a bond price will decline due to a downgrade in its credit rating. Credit ratings, assigned by agencies such as Moody’s or S&P, are indicators of default risk on a particular bond. Lower ratings suggest that a bond issue is riskier than an issue with higher ratings, which in turn leads to a lower price. A downgrade, therefore leads to a lower price. The downgrade risk arises from deteriorating financial condition of a company, and every bond faces this risk to a certain extent.