Risk and Return (Part 2)

What is credit risk?

The short answer is, credit risk is the risk that you won’t get your principal back. When you buy a corporate bond, you’re giving money to a company in exchange for a promise to give you money in the future. The time of repayment is usually fixed and contractual—the company can’t reduce or eliminate payments to its creditors without going through bankruptcy, which usually means stock-owners get wiped out and management loses their jobs.

That’s why companies are usually pretty willing to meet their bond obligations. Not doing so can be a disaster. But whether companies are able to pay is another issue. The risk of non-repayment is embodied in the spread between Treasuries—the risk-free rate—and corporate bonds.

The spread gets wider as credit risk goes up. Ba-rated bond, which are just below investment-grade, yield around 3.5% more than Treasuries. Caa-rated, a much lower grade, yield almost 9% more. This implies a 30% chance of loss for Ba-rated bonds, and a 50% chance for Caa-rated bonds.

The risk of loss is built into these spreads. With investing, you never get something for nothing. But by doing your homework you can manage your risk and add to your return.

Douglas R. Tengdin, CFA

Chief Investment Officer

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