Credit risk is the risk of loss of interest and/or principal stemming from a borrower's failure to repay a loan.

Credit Risk Sources

Chief sources of credit risk include adverse macroeconomic conditions, a financing mismatch between resources and obligations, and issuer-specific factors in corporate and sovereign debt markets.

The "Cs" of credit analysis provide a useful framework for evaluating credit risk.

• Capacity. The capacity, or ability to pay, reflects the funds flow from the organization and the generation of cash sufficient to meet the interest and principal repayments.

• Collateral. Collateral analysis involves not only the traditional pledging of assets to secure the debt, but also the quality and value of those un-pledged assets controlled by the issue.

• Covenants. Covenants deal with limitations and restrictions on the borrower's activities. They impose restrictions on how management operates the company and conducts its financial assets. This term covers both affirmative (obligated to do) and negative (limited in doing) covenants.

• Character. Character relates to the ethical reputation as well as the business qualifications and operating record of the board of directors, management, and executives responsible for the use of the borrowed funds and its repayment.

• Conditions refers to the general environment faced by all borrowers. Country is the geopolitical environment. Currency refers to foreign exchange risk.

Credit Risk Components

Credit risk has two components:

• Default probability addresses the likelihood that a borrower will default on its debt obligations, without reference to estimated loss.

• Loss severity, also known as Loss Given Default (LGD), measures the portion of value an investor loses. If a bond defaults, investors can still expect to recover a certain percentage of the bond; that percentage is called the recovery rate. Loss severity = 1 - recovery rate

Expected loss = Default probability x Loss severity

Consider a 1-year, 4% annual payment corporate bond priced at par. Its expected exposure is $104. Assume a 40% recovery rate, and it applies to both interest and principal. The loss given default is 104 x (1 - 0.4) = 62.4.

The spread refers to the difference between the yield on a specific bond and a comparable maturity (or duration) Treasury. The part of the risk premium representing the default risk is known as the credit spread. If the perception of risk increases for the issuer or for the industry category representing the issuer, the spread may increase or widen. This risk associated with an increasing credit spread is known as the credit spread risk. If there are more concerns about economic security, the spread will widen (implying that the premium for risk increases).

Credit risk could be on account of:

• Downgrade risk: the risk that the issuer will be downgraded, resulting in an increase in the credit spread demanded by the market. The market tends to respond very quickly to news regarding a bond rating decline.

• Market liquidity risk: the widening of the bid-ask spread on an issuer's bonds. The size and the credit quality of the issuer affects market liquidity risk.