What is Credit Risk?
Credit risk is the chance that a bond issuer defaults on its obligations. Rating agencies like Moody's and S&P assign credit ratings from AAA (highest quality) to D (default). US Treasury bonds are considered virtually risk-free, while corporate bonds rated BB+ or below are classified as high-yield or junk bonds. Historically, about 4% of BB-rated bonds default within 5 years, compared to less than 0.1% for AAA-rated bonds.
Credit Spreads
The credit spread is the additional yield a bond pays above the risk-free rate to compensate for default risk. Investment-grade corporate bonds typically offer spreads of 0.5-2.0% above Treasuries, while high-yield bonds offer 3-6% or more. During the 2008 crisis, high-yield spreads spiked above 20%, reflecting extreme fear of widespread defaults. Widening credit spreads often signal economic stress and can serve as an early warning indicator for recessions.
Key Considerations
Diversification is the primary defense against credit risk. Owning a single corporate bond concentrates default risk, but a fund holding hundreds of bonds spreads that risk. Even if 3-5% of holdings default, the higher yields from surviving bonds can offset losses. Japanese Government Bonds (JGBs) carry minimal credit risk but offer very low yields. Investors seeking higher returns must accept some credit risk, but should do so through diversified bond funds rather than individual bond picks.