Credit Risk

Anyone who lends money or is owed payments faces credit risk. Banks face it with loans, bond investors with the companies and governments whose bonds they hold, and businesses with customers who buy on credit.

Credit risk includes the risk of outright default, where the borrower stops paying, and the risk that the borrower's financial health worsens, making default more likely and reducing the value of its debt.

For example, an investor holding bonds of a company whose profits collapse faces higher credit risk. Even before any default, the bond's price may fall as other investors demand a higher yield to compensate for the increased risk.

Lenders manage credit risk by assessing borrowers carefully, requiring collateral, setting limits on how much they lend to any one borrower, diversifying across many borrowers and charging higher interest rates for riskier loans.

Credit ratings from rating agencies summarise credit risk for many bonds and borrowers. The extra yield that a risky bond pays over a government bond of the same maturity, called the credit spread, reflects the market's view of its credit risk.