NISM-Series-X-A: Investment Adviser (Level 1) · Investing in Fixed Income Securities

Credit Risk, Credit Ratings and Other Bond Risks

Updated 11 October 2026 · Fact-checked

Credit risk is the chance that a bond issuer fails to pay interest or principal on time. Rating agencies grade this risk on a scale. Investors demand a credit spread, the extra yield over a government security of similar maturity. Reinvestment, liquidity and call risk are other bond risks you must tell apart.

Understand Credit Risk, Credit Ratings and Other Bond Risks

When you buy a bond, you lend money to the issuer. Credit risk, also called default risk, is the risk that the issuer does not pay interest (coupon) or repay principal as promised. A government security in its own currency is treated as having negligible default risk. A company bond carries more.

In India, credit rating agencies (CRAs) registered with SEBI assess issuers and give a rating to a specific debt instrument. Examples are CRISIL, ICRA, CARE, India Ratings and Acuité. Ratings use letter grades, with AAA at the top, then AA, A, BBB, and so on down to D, which means default. Agencies add + or − signs or modifiers within a grade. A rating is an opinion on the likelihood of timely payment. It is not a guarantee and it is not a buy or sell recommendation.

BBB− and above is called investment grade. Below that is speculative grade, often called junk or high yield. These bonds pay higher yields because the default chance is higher. A rating can be upgraded or downgraded. A downgrade usually makes the bond price fall, because investors now want a higher yield.

The credit spread is the difference between the yield on a corporate bond and the yield on a government security of similar maturity. Lower-rated bonds have wider spreads. Spreads widen when investors fear defaults and narrow when confidence returns. So spread risk is the risk that the spread widens and the price falls even without a default.

Other risks are different from credit risk. Reinvestment risk is the risk that coupons or maturity proceeds are reinvested at a lower rate than the bond's yield. Liquidity risk is the risk that you cannot sell quickly without accepting a lower price. It is higher for lower-rated and thinly traded bonds. Call risk arises when the issuer can redeem the bond early. It does so usually when rates fall, so you get your money back and must reinvest at lower yields.

Key formulas to remember

Credit spread: Credit spread = Yield on corporate bond − Yield on government security of similar maturity; Wider spread means the market sees higher credit risk. Compare bonds of similar maturity only.
Investment grade boundary: Investment grade: BBB− and above. Speculative grade: below BBB−; Rating scale from top: AAA, AA, A, BBB, BB, B, C, D. D means default.
Rating change effect: Downgrade → required yield ↑ → price ↓. Upgrade → required yield ↓ → price ↑; Price and yield move in opposite directions.
Risk direction rules: Reinvestment risk: falling rates hurt. Call risk: falling rates raise it. Liquidity risk: thin trading raises it; Match each risk to its trigger to answer scenario questions.

How to solve Credit Risk, Credit Ratings and Other Bond Risks questions

Use this method for any question on credit risk, ratings or other bond risks.

1Identify what is asked: default, rating, spread, or one of reinvestment, liquidity or call risk.
2Find the trigger in the question. Issuer's weaker finances point to credit risk. Falling market rates point to reinvestment or call risk. Difficulty selling points to liquidity risk.
3For rating questions, place the rating on the scale. BBB− and above is investment grade. Anything below is speculative.
4For spread questions, subtract the government security yield from the corporate yield. Use similar maturity.
5For price effects, remember a downgrade or wider spread lowers the price, and a tighter spread raises it.
6Check the options for traps such as calling a rating a guarantee, or confusing call risk with credit risk.
7Pick the option that matches the exact definition.

Quickest way: Trigger-word matching

When to use it: Use this for definition and scenario MCQs when time is short.

Link keywords to risks: default or downgrade means credit risk; early redemption means call risk; lower rate on coupons means reinvestment risk; cannot sell means liquidity risk.
For spreads, do corporate yield minus government yield and compare the numbers.
Treat BBB− as the cut-off. Above it is investment grade.
Eliminate options that say a rating guarantees repayment.

Common mistakes in Credit Risk, Credit Ratings and Other Bond Risks

Treating a high rating as a guarantee of repayment.
AAA feels like safety.
Fix: A rating is an opinion on the likelihood of timely payment. Even highly rated issuers can be downgraded.
Calling BB bonds investment grade.
Students forget the cut-off.
Fix: Investment grade ends at BBB−. BB+ and below is speculative grade.
Confusing call risk with credit risk.
Both involve the issuer.
Fix: Call risk is early redemption by the issuer, often when rates fall. Credit risk is failure to pay.
Computing the spread against a bond of different maturity.
Students subtract any government yield.
Fix: Use the government security of similar maturity.
Thinking reinvestment risk hurts when rates rise.
Mixing it up with price risk.
Fix: Reinvestment risk bites when rates fall, because proceeds earn less. Rising rates lower the price of bonds you hold.

Worked examples

Example 1

A 5-year corporate bond yields 8.40%. A 5-year government security yields 7.10%. What is the credit spread, and what does it indicate if the spread was 1.00% last month?

Show the solution

Spread = corporate yield − government yield.
8.40% − 7.10% = 1.30%.
Last month it was 1.00%, so the spread has widened by 0.30%.
A wider spread means the market sees more credit risk, so the bond price tends to fall.

Answer: The credit spread is 1.30%. It has widened, which signals higher perceived credit risk and a lower price.

Example 2

An investor holds a high-coupon bond that the issuer can redeem early. Market interest rates fall sharply and the issuer redeems it. The investor must now reinvest at lower yields. Which risk has materialised, and which of these is not a correct description: (a) call risk, (b) the issuer has not defaulted, (c) credit risk, (d) reinvestment problem?

Show the solution

The issuer redeemed early because rates fell. That is call risk.
The issuer paid in full, so there was no default. Credit risk has not occurred.
The investor now faces lower reinvestment rates, which is a reinvestment problem.
So (a), (b) and (d) are correct descriptions. (c) wrongly says credit risk.

Answer: Call risk has materialised. The incorrect description is (c), credit risk.

Exam tips

Memorise the rating scale and the BBB− cut-off. Questions often ask which rating is investment grade.
Read scenarios for the trigger: rates falling, issuer weakening, or no buyers.
Spread numbers are simple subtraction. Do it carefully and check the maturity match.
Watch for absolute words like always or guarantee in rating options. They are usually wrong.
NISM-Series-X-A has negative marking of 25% of the marks of a question, so skip only if you cannot narrow to two options.

Practice questions from Investing in Fixed Income Securities

Credit Risk, Credit Ratings and Other Bond Risks in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk, Credit Ratings and Other Bond Risks: frequently asked questions

What is the difference between investment grade and junk bonds?

Investment grade bonds are rated BBB− or above and have lower default risk. Junk or speculative grade bonds are rated below BBB−. They offer higher yields to compensate for higher default risk.

What is a credit spread?

It is the extra yield a corporate bond offers over a government security of similar maturity. It pays you for taking credit risk. A wider spread signals higher perceived risk.

Who gives credit ratings in India?

SEBI-registered credit rating agencies such as CRISIL, ICRA, CARE, India Ratings and Acuité rate debt instruments. Each rating is an opinion on the issuer's ability to pay on time.

What is the difference between reinvestment risk and call risk?

Reinvestment risk is earning a lower rate when you reinvest coupons or proceeds. Call risk is the issuer redeeming the bond early. Call risk often causes reinvestment risk, but they are different risks.