Entire Site
Free Trial
Safari Books Online is a digital library providing on-demand subscription access to thousands of learning resources.
- Create BookmarkCreate Bookmark
- Create Note or TagCreate Note or Tag
- PrintPrint
CHAPTER 2 - RISKS ASSOCIATED WITH INVESTING IN BONDS > VI. CREDIT RISK
VI. CREDIT RISK
An investor who lends funds by purchasing a bond issue is exposed to credit risk. There are three types of credit risk:
1. default risk
2. credit spread risk
3. downgrade risk
We discuss each type below.
A. Default Risk
Default risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal.
Studies have examined the probability of issuers defaulting. The percentage of a population of bonds that is expected to default is called the default rate. If a default occurs, this does not mean the investor loses the entire amount invested. An investor can expect to recover a certain percentage of the investment. This is called the recovery rate. Given the default rate and the recovery rate, the estimated expected loss due to a default can be computed. We will explain the findings of studies on default rates and recovery rates in Chapter 3.