Why is credit risk particularly significant for bond investors?

Credit risk is particularly significant for bond investors because it directly impacts the likelihood that the issuer of the bond will fulfill their payment obligations. When investors purchase bonds, they are essentially lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at maturity. If the issuer faces financial difficulties or defaults, the bondholder may not receive the expected interest payments or the principal amount, leading to a loss.

This risk is paramount for investors because it can erode the expected returns and can vary significantly among different issuers. For example, bonds issued by companies with lower credit ratings (high yield or junk bonds) generally offer higher interest rates to compensate for the greater credit risk, compared to bonds issued by government entities or highly rated corporations, which are perceived as safer investments. Understanding credit risk allows investors to make informed decisions regarding their bond investments, balancing potential returns with the associated risks.