The credit risk is the risk of a firm defaulting on their debt. This is also known as default risk, the risk of a borrower failing to repay the debt. This risk is deeply associated with the financial stability of the issuer. The lowest credit risk is a high financial stability, where it is close to impossible to default. The highest credit risk is immediately before bankruptcy or default. A firm declaring bankruptcy is at the highest default chance.
There are several ways you can attempt to counter, or even reverse, credit risk. The first thing you can do is acknowledge the credit ratings of the bonds you have purchased. Investing in high investment grades reduces the chances of you picking firms which are on the verge of default. High ratings in the AAA and AA range are least likely to default. These are the highest ratings in the investment grade, which is composed of ratings between BBB to AAA. Investing in these bonds adds some amount of stability to your portfolio, but returns lower yields on the bond spectrum.
Bonds rated below BB are substantially more likely to default, and the risk gets higher the lower the rating. The ratings below BB are known as junk bonds due to their likelihood to default. These bonds must also deliver extremely high yields to make purchasing them worthwhile. Junk bonds are alternatively labeled High Yield Bonds to recognize this reality. Investing in these bonds adds higher yields to your portfolio at the expense of stability. These bonds are substantially riskier than investment grades.
You can also avoid credit risk by being careful about the types of bonds which compose your portfolio. Government issued, or Sovereign bonds, default at a substantially lower rate than corporate bonds. This is due to governments being able to print their own currency in order to pay down their debt. Investing in AAA rated governments usually results in stable returns. However, you should still investigate the financial status of the government. A highly rated government with little debt compared to GDP and substantial tax revenue has higher stability than bond issuers with high debts and low tax revenue. Governments can still go bankrupt or have their currency values collapse.
Lastly, it is best to spread your risk if you are considering investing in bonds. If you are building a bond portfolio, you should be investing in a large sum of bonds. You should not build a bond portfolio of 5 or 6 issuers, even if they are investment grade. If one issuer defaults, your gains can become overall losses. A single default can wipe you out. Your portfolio should compose of hundreds of bonds. Typically, this involves hundreds of thousands of dollars. Alternatively, you can utilize bond funds composed of varying amounts of issuers. You should be sure to invest only in bond funds which specifically match the credit rating, issuer type, and domestic locations you wish to invest in. If possible, review ratings of bond issuers held by the fund.
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