What is a Credit Risk?
A credit risk is the amount of potential for default that is inherent in a given debt investment or extension of credit. A lender or an investor in various types of bonds carries a degree of credit risk on any transaction conducted. Assessing the degree of risk involved is essential before completing any type of lending or investment transaction.
In the case of lending money, the entity that provides the loan carries the credit risk. For this reason, a lender will want to know pertinent information regarding the ability of the borrower to repay the amount of the loan, including all finance charges and related fees. If the lender is unable to determine that the borrower will be able to repay the loan, the borrower may be considered a poor risk and be denied.
With the purchase of bond issues, it is the buyer who assumes a degree of credit risk. Bonds generally carry a commitment on the part of the bond issuer to provide the buyer with full repayment of the purchase price of the bond at some future point. As part of the transaction, the buyer also anticipates some type of dividend or interest payment in exchange for the purchase of the bond. If the bond issuer is not likely to be able to repay the principal or provide interest payments as outlined in the terms of the bond, the issuer is understood to be a poor risk.
Just about any type of transaction that involves the extension of credit in some form carries a degree of credit risk. In many cases, the level of risk is very low and thus considered acceptable. At the same time, it is important to explore all relevant factors before assuming any degree of credit risk. Failure to do so can result in a loss to a lender or bond investor that may be significant.
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