Investor Corner/The asset classes/Debt Concepts
2.2.6 Credit Risk / Default Risk
Credit risk, also called default risk, is the possibility that a borrower fails to pay the interest or principal it owes. Higher credit risk is generally compensated with a higher yield.
The risk behind the extra yield
When a corporate bond offers a noticeably higher yield than a government security of similar maturity, that gap exists because the market perceives a real chance the company could struggle to pay. Government securities are generally treated as close to free of default risk, since a government can raise taxes or, in extreme cases, print currency to meet rupee obligations. A private company has no such backstop.
Credit risk is the possibility that a bond issuer will fail to make interest payments or repay the principal on time. At the extreme, it is outright default. In milder forms, it is a credit rating downgrade that signals deteriorating financial health, causing the bond's market price to fall even before any actual payment is missed. Government securities are considered free of credit risk in domestic currency because the government can, in theory, always raise taxes or print money to honour its obligations. Corporate bonds carry varying degrees of credit risk depending on the issuer's financial strength.
How the market prices this risk
The extra yield a risky borrower must offer over a safer one is called the credit spread. That spread widens during economic stress, when default fears rise across the board, and narrows during calm periods when investors feel more confident lending to weaker borrowers. Watching how credit spreads move is one way analysts gauge the market's collective mood about economic risk.
Credit risk is priced through the credit spread: the additional yield a corporate bond offers above a government bond of the same maturity. A AAA-rated corporate bond might offer 30-50 basis points above the equivalent G-Sec. An AA-rated bond might offer 80-120 basis points. Lower-rated bonds (A, BBB) offer even higher spreads. The spread compensates the investor for the statistical probability of default, adjusted for expected recovery. When credit conditions tighten (during an economic slowdown or a banking crisis), spreads widen sharply because the perceived probability of default rises; when conditions are benign, spreads compress.
India has experienced several high-profile debt defaults and near-defaults in recent years, including IL&FS (2018), DHFL, and several Anil Ambani group companies. These events affected not only direct bondholders but also investors in credit risk funds and corporate bond funds that held the defaulted paper. NAVs fell sharply overnight, and in some cases, funds had to side-pocket the affected securities, locking investors out of a portion of their capital for extended periods.
Managing the risk sensibly
Credit risk is not something to avoid altogether; it is something to be compensated fairly for. The key questions are whether the extra yield on offer genuinely compensates for the added risk, and whether that risk is appropriately sized within the overall portfolio rather than concentrated in a way that a single default could seriously damage.
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For retail investors, the simplest way to manage credit risk in debt allocation is to stick with funds that hold predominantly sovereign or AAA-rated corporate bonds. The incremental yield from lower-rated paper is rarely worth the tail risk of a default, especially for money with a specific goal attached. Credit risk funds and high-yield strategies are niche products best suited for investors who understand the risks, can absorb a concentrated loss, and do not need the capital on a specific date.