4.5.11. Credit Risk and Ratings
The three types of credit risk are:
- • Default risk
- • Credit spread risk
- • Credit deterioration risk
Default risk is the risk that the issuer will fail to meet its periodic payment obligations in a timely manner. In other words, it is the risk that the issuer will default on the bond. It is generally measured and monitored by the credit rating agencies Moody’s, Standard & Poor’s, and Fitch. Higher ratings mean higher marketability. Bonds with high credit quality have more liquidity, because they fit more investors’ profiles. Banks and insurance companies are often required to invest only in securities that are rated investment grade (BBB or better).
Credit spread risk is the risk of a thin secondary market for the bond. A wide spread between the bid and ask price is a good indication that a security’s marketability is weak. If you own such a security and wish to sell it, you may not sell it quickly or get the price you think the security deserves.
Credit deterioration risk is the risk of a credit downgrade. Small entities are often more vulnerable to credit deterioration than larger ones. Municipalities that are a sole provider or offer essential services may be less vulnerable to a downgrade than those whose projects face competition or whose products are vulnerable to the business cycle. For example, bonds issued to build a new water treatment plant in a town where there is no competition and no other source of municipal water may be less vulnerable to a downgrade than a bond issued to support the construction of a toll bridge where there are other viable routes.
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Summary Table |
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Issuer name |
Name recognition broadens the market for bonds |
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Source of funds |
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