Credit risk measures the likelihood of incurring a loss if one party to a financial transaction fails to follow through on their obligations.
Credit risk often comes up when in relation lending and how likely an individual or business entity is to pay back money they’ve borrowed. Banks and lenders assume a certain amount of risk when making loans, based on the credit profile of the borrower. If you’ve ever taken out a loan or line of credit, your credit risk was likely one factor that influenced the interest rate that you paid.
Understanding how to interpret this concept is important for investors, as it can affect returns for certain types of fixed-income investments. Here’s a primer on credit risk and how it works.
Understanding Credit Risk
How you define credit risk depends on the circumstances in which it’s being measured.
For instance, when banks or lenders make loans there’s an assumption that the loan will be repaid. Credit risk accounts for the possibility that the borrower will fail to repay what’s owed, leaving the lender with interrupted cash flow, costs to recover the funds, and ultimately a financial loss.
This same principle operates when a vendor extends a line of credit to a business. They’re taking a gamble on the business paying them back on schedule for the services or products they’ve provided.
Credit risk is also linked to other types of risk. For example, counterparty risk represents the probability that one party in an investment, credit or trading transaction will not fulfill their part of the bargain. This is also called default risk, as it measures the odds that a party to a financial transaction will default or fail to make required payments as scheduled.
In terms of investing, another credit risk definition applies when discussing bonds. A bond represents a form of debt. When an investor purchases a bond, they’re effectively lending their capital to the bond issuer for a set time period. During this time period, the bond issuer makes interest payments to the investor. Once the bond matures, the bond issuer pays back the investor’s original principal.
The investment is made in good faith, as the investor assumes the bond issuer will make interest payments and return their principal. But the bond issuer could default on their end of the deal — this is credit risk. Credit ratings help investors determine when a bond investment has a higher or lower level of credit risk.
The Five C’s of Credit
When measuring credit risk, it’s common to turn to the five C’s of credit. These are five factors used to evaluate how likely an individual or business is to follow through on their end of a financial contract.
The five C’s of credit are more often used in business lending than personal lending. If you’re getting a personal loan, line of credit or credit card, for example, lenders are more likely to consider your FICO credit scores. The FICO credit score range runs from 300 to 850, with 850 being the highest score you can achieve.
Recommended: What’s Considered a Bad Credit Score?
With that in mind, here’s how the five C’s break down.
Character is an assessment of a borrower’s background. This can include their level of education, experience operating a business and overall reputation. Lenders may also look at someone’s personal credit history to gauge their character and measure credit risk when granting business loans.
Cash flow represents the movement of cash in and out of a business. In lending situations, cash flow is often synonymous with the ability to repay what you borrow. Lenders can use business revenues, expenses, and cash flow to determine credit risk.
Capital is a measure of how much skin you have in the game, so to speak, in terms of how much money you’ve personally invested in your business. The more money you have tied up in a business venture, the less likely you may be to default on a loan and jeopardize the business. That’s a positive in terms of assigning credit risk.
Conditions refers to the business’ overall market. For example, lenders will look at how much demand there is for the products or services your business offers as well as your competitors. Your experience with operating this type of business can also come into play.
Collateral is used to mitigate credit risk by requiring you to offer some type of security against a loan. For example, if you’re getting a loan to buy equipment the equipment itself could serve as collateral. If you default on the loan, the lender can repossess the equipment and sell it to try and recoup some of its losses.
Credit Risk and Interest Rates
Credit risk has a link to interest rates, both in terms of the rates you might pay to borrow and the rates you might earn from an investment. The relationship is inverse on both sides.
For example, in lending a higher credit score can translate to lower credit risk and therefore, lower interest rates. With investing, a lower credit score could result in a higher credit risk and higher interest rates.
Why This Matters to Borrowers
Credit risk matters to borrowers because it can directly affect what you pay for loans. The lower your credit score, the riskier you may appear in the eyes of lenders. To offset this risk, the lender may charge a higher interest rate.
When that interest is amortized, you typically end up paying more toward the interest versus the principal early on the life of the loan. This allows the lender to collect the bulk of the interest upfront to compensate for the risk that you default down the line.
In that sense, higher interest rates are an insurance policy of sorts for the lender when the perceived credit risk is higher. But what it ultimately means for you is that borrowing money is more expensive.
Why This Matters to Investors
Credit risk and interest rates also matter to investors when trading bonds. Bonds with better credit ratings are likely to have less credit risk, as there’s less potential for the bond issuer to default. But they may carry lower interest rates as a result. On the other hand, bond issuers with lower credit ratings may offer higher interest rates to incentivize investors to purchase them.
It’s also possible to create credit risk for yourself if you’re trading on margin. Margin trading involves borrowing money from a brokerage to invest. So here’s how margin accounts work:
• You deposit a minimum margin amount ($2,000 under FINRA rules, though some brokerages may require more)
• Your brokerage allows you to borrow up to 50% of the purchase price of margin securities (this is known as initial margin)
• Your brokerage requires you to observe a maintenance margin level going forward
Credit risk exists because you’re using borrowed money to invest. If your investments don’t perform as expected, you could lose money, and you’d still be obligated to repay the brokerage. This can happen if your account balance drops below the maintenance margin level and you become subject to a margin call. If you’re subject to a margin call you generally won’t be able to make additional investments until you’ve deposited more funds into your account.
Recommended: What You Need to Know About Margin Balance
How to Assess Credit Risk
The method for assessing credit risk depends on the situation in which it’s being measured. As already mentioned with business lending, lenders rely on the five C’s of credit to gauge a borrower’s credit risk. These five factors, along with personal and business credit score and their overall financial position can help determine how likely a borrower is to keep up with their debt obligations.
In investment settings, particularly with bonds, investors can use official credit ratings as a guide. Moody’s , for example, is one of the best-known issuers of bond credit ratings. Altogether there are nine credit rating agencies registered as nationally recognized statistical ratings organizations (NRSROs) with the Securities and Exchange Commission (SEC).
It’s important to remember, however, that credit ratings alone are not a foolproof indicator of risk. You must also evaluate the specifics of the investment itself as well as your own personal risk tolerance to decide if a particular bond is a worthwhile investment. This is all part of performing due diligence, which is important for managing all types of risk, including credit risk.
How Credit Risk Applies to You
This depends on how you invest or borrow money. If you own bonds, for example, you’re assuming a certain amount of credit risk based on the quality of the bonds in your portfolio. A bond with a AAA credit rating, for example, is less of a credit risk compared to a bond with C rating.
Choosing to invest in junk bonds, which carry a higher degree of credit risk, could prove profitable if the bond issuers make good on interest payments. But in exchange, you’re shouldering a greater amount of risk since the bond has a lower credit rating. So understanding your personal risk tolerance is key when choosing investments.
Credit risk also plays a part in borrowing decisions. If you have a good credit score, then getting a loan or line of credit at a lower interest rate may be relatively easy. On the other hand, if you have fair or bad credit that could mean paying higher interest rates. Taking steps to improve your credit score could help you to qualify for more favorable interest rates.
Start Investing With SoFi Today
Understanding a basic credit risk definition is important if you plan to invest in bonds or other fixed-income investments. If you’re ready to start building a portfolio, online stock trading with SoFi can help.
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