How Credit Risk Can Cause Losses in Fixed-Income Investments

Two losses that look the same and are not

Ramesh holds two debt funds and both are down. One fell because interest rates rose; the other fell because a company it lent to was downgraded. On his statement the two look identical — a smaller number than last month, in roughly the same proportion.

They are not the same thing at all, and the difference determines what he should do about each.

Interest-rate risk moves prices. If rates rise, a bond falls in value, but the issuer still pays the coupons and still repays the principal, so holding to maturity recovers the loss. It is a timing problem, and patience is a genuine remedy.

Credit risk is the possibility that the borrower does not pay. Money not repaid does not come back by waiting. Recovery proceedings may return part of it, slowly, and there is no maturity date at which the problem resolves itself.

That asymmetry is why the two should never be discussed as a single number called "risk". Ramesh can absorb the first fund's fall by doing nothing. Doing nothing does not help with the second.

How credit losses actually arrive

Rarely as a sudden bankruptcy. Usually as a sequence, and the early stages are where most of the damage to a fund's value is done.

It begins with a downgrade: a rating agency reduces its assessment, the bond's price falls immediately because buyers now demand more yield to hold it, and holders have lost money before anybody has missed a payment. Often the market moves first, with the extra yield demanded over government bonds widening in advance of the agencies catching up.

Then liquidity goes. Buyers disappear, the bond can no longer be sold at anything like its marked value, and that matters enormously for a fund facing redemptions. A missed payment or a restructuring follows, destroying value even where the principal is eventually repaid. Default is merely the permanent version at the end of the sequence.

The point worth carrying is that a holder can be hurt badly at any stage of that. Waiting for an actual default before worrying misunderstands where the losses occur.

Why a fund can lose money without a default

This is the mechanism that surprises Indian investors most, and it deserves setting out carefully.

A debt fund's value is the value of its holdings. When a holding is downgraded or becomes hard to sell, it is marked down, and every unit holder's value falls that day. No payment has been missed by anyone.

Then a second effect can begin. Investors seeing the fall redeem, and to pay them the fund sells what it can — which is its good, liquid holdings, because the impaired ones cannot be sold. The investors who remain are left holding a portfolio containing a higher proportion of the problem. If redemptions continue, the fund may restrict them, or place the affected holding into a segregated portfolio, freezing that part of everybody's money until recovery, if any arrives.

None of that requires the borrower to have formally defaulted. It requires only that the market decides the borrower might.

Where the extra yield comes from

Here is the principle that does most of the practical work. In fixed income, extra yield is payment for accepting something — almost never a free lunch, and almost always one of credit risk, longer duration, illiquidity, or an option that benefits the issuer rather than you.

So a fund or a bond offering noticeably more than comparable alternatives is not better managed. It is taking more of something, and the question is never why the yield is higher in the abstract but which of those four it is and whether the payment is adequate.

The uncomfortable corollary is that credit risk pays you steadily and charges you suddenly. A portfolio of weaker borrowers produces slightly better returns for years, which looks a great deal like skill, and then loses several years of that advantage in a single event. Judging such a fund by its past returns during the quiet stretch is judging it on the half of the cycle that has already happened.

What ratings are and are not

Ratings are opinions about the relative likelihood of default, produced by agencies paid, under most models, by the issuer. They are genuinely useful, since a systematically compiled view beats nothing, and they have specific limits worth knowing.

They are revised, sometimes sharply and often after the market has already repriced the bond. They say nothing about how much you would recover in a default. They do not measure liquidity at all. And a rating on a structured obligation can rest on assumptions that are themselves the risk.

Use them as a filter rather than as a verdict, and pay attention when a bond's yield disagrees with its rating. The market's price is a live opinion; a rating is a periodic one.

What to check

Look at the portfolio rather than the category name, because the holdings disclosure is the only place the risk is actually visible. Check concentration separately, since a single large holding in a weak borrower is a different proposition from the same exposure spread thinly.

Compare the yield against peers, and if it is higher, find out why — that question has an answer and it is usually sitting in the portfolio. Ask what would happen under stress, because government securities and paper from large, frequently traded issuers behave very differently from thin corporate paper on a bad day, even though both look liquid on a calm one.

And ask whether you are actually being paid. The extra yield over a safe alternative is the compensation, and it is worth asking whether a fraction of a per cent a year is adequate payment for the possibility of losing a meaningful part of the principal. For money whose job is safety, it frequently is not.

Matching the risk to the job

The cleanest way to avoid credit losses is to be clear about what the money is for.

Money whose purpose is safety — an emergency fund, a near-term goal, the stable part of a portfolio — should not be taking credit risk to earn slightly more, because the extra return is small and the failure mode defeats the entire purpose of holding it. Money whose purpose is return is generally better served by equity than by lending to weak borrowers, since credit risk in a portfolio often sits in an awkward middle: too risky for the safe allocation, too capped in upside for the growth one.

That is not an argument that credit exposure is never appropriate. It is an argument for holding it deliberately, sized as a risk asset, rather than accidentally inside something labelled conservative — which is how Ramesh came to own the second fund without ever deciding to take the risk it carries.

What to take away

Rate losses reverse with time and credit losses do not, and that asymmetry should govern how you think about anything you lend money to.

Losses arrive through downgrades, widening spreads and illiquidity long before any formal default, and a debt fund can be marked down, restricted or side-pocketed without a borrower missing a payment. Extra yield always pays you for accepting something — identify which before taking it. And keep credit risk well away from the money whose entire job is to be there when you need it.