Credit risk

Credit risk — also called default risk — is the possibility that whoever you lent money to cannot pay you back as promised. It applies to corporate bonds, debentures, company deposits and the bonds held inside debt mutual funds. Securities issued by the central government are generally regarded as carrying the lowest credit risk in the domestic market.

Why it matters

Credit events tend to be sudden and can be severe. A default can wipe out much of a bond’s value, and even a downgrade can cause a sharp price fall. In a debt fund, one troubled holding can pull down the NAV for every investor in the scheme.

How to read it

• Credit ratings are a starting point, not a promise. Read the rating rationale for the issuer’s business, borrowing and outlook.
• Credit spread. The extra yield a bond offers over a government security of similar maturity is the market’s price for its credit risk.
• Concentration. Spreading exposure across issuers and sectors limits the damage any one default can do.
• Security and seniority. Secured and senior debt usually ranks ahead of unsecured or subordinated debt if things go wrong.

Common misconceptions

• “A fixed deposit can’t default.” Bank deposits are covered by deposit insurance up to a limit. Corporate and NBFC deposits are outside that scheme and carry the issuer’s credit risk.
• “Debt funds are safe because they aren’t equity.” Debt funds carry credit risk and interest rate risk; how much depends on what they hold.

In India: Debt fund factsheets disclose the portfolio’s rating mix and holdings periodically. Check them before investing, and again from time to time.