Explaining credit risk

Last month we talked about interest rate risk – the risk of your investment devaluing and you losing money due to changes in interest rate. In a sense, this is about an investment’s possibility of flailing due to macroeconomic conditions. This month, we’re going to look at credit risk.

Credit risk is a very different type of risk to interest rate risk, and largely impacts the one extending the credit. It’s the risk that credit (what is owed) is not repaid. So, if a bank loans a business capital, the credit risk would refer to the chance that the business goes into business rescue or another situation in which the bank does not get the interest owed to it on the loan and cannot recoup that loss but must, instead, write it off.

Traditionally, credit risk is defined by risks taken in investing/lending to someone without them paying an upfront sum. These types of risk almost always come with interest charged to the borrower or loan recipient, along with the repayment of the loan amount. In a sense, you could almost say that interest on a loan is the ‘payback’ an institution gets for taking the risk in lending out money – which explains why higher interest rates are charged for higher risk entities. A business in its infancy will pose a higher credit risk compared with one that is more established and proven its financial viability.

What do you need to know about credit risk?

Credit risk in your business – This risk affects you very materially if you have your own business and must deal with clients. Unless you charge upfront or require down payments, you are essentially taking on credit risk every time you do work for a client in the hopes that they will pay you later. For this reason, it’s worth looking into companies’ reliability with honouring debts before going into business with them.

Credit risk as an investor – If you are an investor, credit risk signifies the risk to you that a bond you’ve invested in may default and you’ll have to write off the sum you invested there. This can be a good strategy for investors when the company invested in is on a solid upward trajectory and the economy is too. The higher the risk is, generally, the higher the possible reward, so it’s a potentially dangerous game that really requires the help of professional advice.

Credit risk, just like any other type of risk, is not something to be feared or avoided. Not if you want to create wealth, that is. Rather, like each type of risk, it is to be understood and taken seriously, discussed with a professional before making any serious investments and decisions.

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