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Credit risk is the risk that a party cannot meet its financial obligations. This means that a borrower does not pay interest or repay the principal as agreed. For investors, credit risk mainly plays a role in bonds and loans.
The weaker the financial position of a borrower, the greater the credit risk.
When you buy a bond, you lend money to a company or government. You expect to receive interest and to get your principal back at the end of the term. If the issuing party runs into financial difficulties, there is a chance that payments will be delayed or not fully repaid. Investors therefore often demand a higher interest rate when credit risk is greater. Credit rating agencies sometimes assign a rating to indicate how high this risk is estimated to be.
Short example:
Suppose you lend €1,000 to a company through a bond at 5% interest per year. You expect to receive €50 in interest annually and to get your €1,000 back after five years.
If the company goes bankrupt and can only repay €600, you lose €400 of your original investment. That loss is the result of credit risk.
Disclaimer: Investing involves risks. Our analysts are not financial advisors. Always consult a professional advisor when making financial decisions. The information and tips provided on this website are based on the personal insights and experience of our analysts and are intended for educational purposes only.
