An investor faced various kinds of risks when investing in different asset classes. This is true even for debt investment because there are peculiar risks present.
While the attention is focused on possibility of some sort of interest rate risk, another graver risk is often ignored. This is the credit risk; present in particular types of investments. Considering the risk and taking steps to tackle it is important for every investor.
This risk is present in most debt investments. The risk is that the entity issuing the debt might be unable to pay the debt
amount, resulting in loss of capital to the investor.
This will happen when the position of the entity issuing the debt deteriorates and it is unable to pay the required amount. First the interest payments might stop and then even repayment of capital might become tough. This has been witnessed in several instruments in India in the past and that is the reason why investors need to be aware of the position.
This kind of risk is seen in debt instruments where it is essential that the performance of the company is strong enough to generate the necessary payments through a regular cash flow.
There is a feature called ‘credit rating’ in the market, which helps an investor understand risks involved in these types of instruments. The credit rating gives an indication about the financial position of the entity. Stronger the position, the better it is for the investor. The risk here could be that over a period of time the financial position deteriorates resulting in repayment problems.
There is exposure by investors to this kind of risk whenever they go towards debt instruments. This might be direct or there can even be an indirect exposure.
When an investor directly holds a bond or a debenture of some company or a financial institution, then the exposure will be direct. In other cases there might be holding of a mutual fund where the fund has instruments in the portfolio. In case of a default, even in this position, the investor will eventually have to bear the loss. Understanding this and knowing the risk is an important component of the entire process.