Forms of credit risk

by Rosa Geminava.
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There are three types of credit risk.

  • Default risk: the risk that the issuer will default on its obligations (timely payment of interest and repayment of the amount borrowed). The percentage of bonds expected to default in a specified population of bonds is called a default rate. If a bond defaults, investors can still expect to recover a certain percentage of the bond, and that percentage is called the recovery rate.
  • Quality spread or credit spread: it is the risk premium which is the premium above the yield on a default-free bond issue necessary to compensate for the risks associated with the bond. It is attributable to default risk, and varies over business cycles. The risk that the price of a bond will drop due to an increasing credit spread is called credit spread risk (investors "flight to quality" during economic recessions).
  • Downgrade risk: it is the risk caused by unanticipated deterioration in the credit rating of an issue. It is closely related to credit spread risk.

Rating agencies examine the issuer's ability to service its debt obligations in a timely manner. They assign a credit rating to each issue. In all systems the term high grade means low credit risk. Investors can use the credit ratings to gauge the default risk of an issue. Three major rating agencies in the US are S&P, Moody's and Fitch.
Both default potential and credit ratings changes drive credit spread risk.

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