Default Risk- Default risk is the risk that the issuer will go belly up and not be able to pay its obligations of interest and principle. To help measure this risk, an investor can look at default rates. A default rate is the percentage of a population of bonds that are expected to default. Another ratio that an investor can look at is the recovery rate. This rate indicates how much and investor can expect to get back if a default occurs.
Credit Spread Risk- This second type of credit risk deals with how the spread of an issue over the treasury curve will react. For example, Ford five-year bonds may trade at 50 basis points above the current five-year treasury. If the five-year bond is trading at 3.5%, then the Ford bonds are trading at a yield of 4%. If this spread of 50 bps widens out compared to other bond issues, it would mean that the Ford bonds are not performing as well as the other bonds in the marketplace. Spreads tend to widen in poor performing economies.
Downgrade Risk -The third type of credit risk deals with the rating agencies. These agencies, such as Moody's, S&P and Fitch, give an issuer a rating or grade that indicates the possibility of default. On the more secure side, the ratings range from AAA, which is the best rating to AA, A, BBB. These are the ratings for investment-grade bonds. Once bonds dip into the BB, B, CCC ranges they become junk bonds or, in politically correct language, high yield securities. If one of these rating agencies downgrades a company's rating, it may be harder for the corporation to pay. This will typically cause its marker value to decrease. That is what this risk is all about.