Credit risk

Credit risk is the risk that a borrower, whether a bond issuer, a bank, or any other counterparty, fails to make interest payments or repay principal as promised. It is distinct from interest rate risk, which affects a bond's market price even when the issuer is fully expected to pay on time, credit risk is specifically about the issuer's ability and willingness to honor its obligations at all.

Credit rating agencies assess this risk and assign ratings that sort bonds into broad categories, commonly split between investment-grade bonds, considered to have low default risk, and high-yield bonds, which carry meaningfully higher default risk and compensate investors with a higher coupon. A bond's credit spread, the extra yield it offers over a comparable Treasury, is largely a market-based measure of how much credit risk investors believe they are taking on.

Credit risk is not limited to corporate bonds. Municipal bonds, agency bonds, and even some sovereign bonds each carry their own level of credit risk depending on the financial health of the issuing entity. An investor managing credit risk typically diversifies across issuers and industries rather than concentrating in a small number of bonds, since a single unexpected default can wipe out years of coupon income from that position.