The term credit risk is almost always associated with consumer lending and the risk lenders take in financing a client, but in the context of the markets and investing, credit risk relates to a bond’s sensitivity to default.
The two most common types of investments that have credit risk are corporate and government bonds. Essentially, credit risk assesses the likelihood that an entity will not be able to meet its financial obligations to its investors. Corporate bonds tend to carry more risk than government bonds because they are debentures, or not secured by collateral.
A handful of agencies like Standard & Poor’s, Moody’s, and Fitch’s provide their guidelines. However, outside of these agencies, there are two other ways to assess credit risk. Interest-coverage ratios determine risk by looking at how much money is generated from the interest to cover the debt, and typically businesses should aim for a higher ratio. Alternatively, capitalization ratios determine risk by looking at how much interest-bearing debt a business has compared to its assets, and the lower the ratio the better the outlook.