How does credit risk affect bond investments?

Credit risk is a critical factor in bond investments because it directly pertains to the likelihood that the issuer of the bond may be unable to meet their financial obligations, specifically the payment of interest or the repayment of the principal at maturity. When investors consider a bond, they assess the creditworthiness of the issuer, which reflects their ability to generate sufficient cash flows to service their debt. If there is a high perceived credit risk, investors may demand higher yields as compensation for the added risk of possible default.

This risk influences various aspects of bond investments, including pricing, yield, and overall investment strategy. When credit risk is elevated, it can lead to a decline in the bond's price in the secondary market, reflecting the increased likelihood of default. Consequently, understanding credit risk is essential for evaluating the overall risk and potential return associated with bond investments.

Liquidity, yield determination, and restrictions on the types of bonds purchased are certainly influenced by credit risk, but they are secondary factors that do not address the fundamental issue of the issuer's ability to meet its obligations, which is captured directly by recognizing credit risk.