Assessing Credit Risk – Peppystores


Promises of higher returns can be misleading. Investors need to exercise caution

Promises of higher returns can be misleading. Investors need to exercise caution

Rajesh asks his colleague Parag to lend him £400. Rajesh assures Parag that he will return the money in the evening after he has had a chance to withdraw it from the ATM.

Rajesh only had a £2,000 note and needed change for his lunch etc. They’ve been friends for years and it was a no brainer. Even if Rajesh had said, “I’ll pay you tomorrow,” Parag wouldn’t have worried.

In this case, the credit risk for Parag, ie the possibility that Rajesh would not repay the amount, was insignificant. Even if Rajesh had forgotten, Parag wouldn’t have cared.

term, risk

Assuming Rajesh had said he would pay it back after three months, Parag would have thought it odd. He would not have turned down the request to loan Rajesh the money, but a question would have popped into his head; this would have implied that there was a credit risk. Still, Parag could have borrowed the money. The first principle of credit risk is that credit risk increases with tenure.

Familiarity with Borrower

Now suppose the clerk in a neighboring office had asked Parag for £400. If Parag didn’t know this peon, he might have refused or been a bit reluctant to lend him anything.

The next factor to consider is borrower familiarity. If the borrower is not known, there is a higher risk.

In the examples above, money was lent without any security. Often money is lent against collateral, for example when we lend money to someone by requiring some form of collateral from the borrower. In doing so, we not only evaluate the borrower but also the quality of the thing to be secured (asset); When we lend someone money for gold, we want to evaluate the quality/purity of the gold.

There are several factors we consider before lending money. We do this because we want to be sure that money borrowed is returned to us on time. Even if interest is payable to us, we want it to be paid on time. All of these checks are designed to mitigate credit risk.

Just as we lend money to individuals, we also lend to banks; When we deposit money into savings accounts, invest in time deposits, etc., we actually lend it to them. When we invest in bonds, debentures, etc., we are actually lending money to the institution that is issuing them. It is important to assess the risk associated with this lending. We need to check how safe the principal is and how safe it will be to pay interest on time. This can be checked in detail using the offer document. Find out about the institution, its past performance, its ratings – there are rating agencies that assess the safety of principal and timely payment of interest – whether the amount borrowed is backed by specific assets and the quality of those assets.

I’m often asked if I should invest in a certain type of bond or debenture because it’s worth about a percentage point or two more. “My standard answer is: how much are you investing and how much more money are you going to make?”

Let’s understand this with an example. Suppose an individual wants to invest £10,000 in a bond that yields 2% more annually than a bank deposit. Bank deposits are always safe. The higher return in real money means it’s ₹200 more per year.

The investor has to decide whether it is worth taking this extra risk for ₹200 more per year. Liquidity, i.e. simple redemption of bonds, is either not possible or cumbersome.

Credit risk is the risk of default on a debt that may arise from a borrower’s failure to make required payments. Lured by the promise of higher interest rates, we sometimes take unnecessary credit risks. Always remember that the higher the interest rate, the greater the risk.

(The author is a financial planner and author of Yogic Wealth)

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