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NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors · Investing in Fixed Income Securities (NISM XXI-A)

Credit Risk and Credit Ratings for NISM XXI-A

Updated 11 October 2026 · Fact-checked

Credit risk is the chance that a bond issuer fails to pay interest or principal on time. Credit rating agencies such as CRISIL and ICRA grade issuers with letter ratings. Lower ratings mean higher default risk, so investors demand a higher credit spread over a risk-free benchmark yield.

Understand Credit Risk and Credit Ratings

Credit risk (also called default risk) is the risk that the issuer of a debt security does not pay interest or repay principal as promised. A government bond has very low credit risk in its own currency. A corporate bond has more. The weaker the issuer, the higher the risk.

Investors are paid for taking this risk. The extra yield a bond offers over a risk-free benchmark of similar maturity is the credit spread. A riskier issuer must offer a wider spread to attract buyers. If the market thinks an issuer is getting weaker, its spread widens and its bond price falls, even if no default has happened. This is spread risk.

A credit rating is an independent opinion on how likely an issuer or a specific instrument is to pay on time. In India, SEBI-registered credit rating agencies such as CRISIL, ICRA, CARE and India Ratings give these opinions. Ratings use letters. AAA is the highest safety. Ratings in the AAA to BBB band are investment grade. Ratings of BB and below are speculative grade (non-investment grade). D means the issuer is in default. Agencies add the suffixes + and - and an outlook (positive, stable, negative) to show small differences.

A rating is an opinion, not a guarantee and not a buy or sell recommendation. It can change. An upgrade usually narrows the spread and lifts the price. A downgrade does the opposite. Ratings apply to the instrument, so the same company can have different ratings on a secured bond and an unsecured one.

Credit risk is one of several fixed income risks. The others you should know are interest rate risk, reinvestment risk, liquidity risk, call risk and inflation risk. Exam questions often ask you to match a situation to the right risk.

Key formulas to remember

Credit spread
Credit spread = Yield on the corporate bond − Yield on a risk-free government security of similar maturity
Compare bonds of similar maturity. A wider spread means the market sees higher credit risk.
Spread direction rule
Downgrade or weaker outlook → spread widens → price falls
Upgrade does the reverse: spread narrows and price rises.
Rating bands
AAA to BBB = investment grade; BB and below = speculative grade; D = default
Higher letters mean lower default risk and usually lower yield.
Expected loss idea
Expected loss = Probability of default × Loss given default
Loss given default is the share of the investment lost if default happens. Recovery reduces it.

How to solve Credit Risk and Credit Ratings questions

Use this order for any question on credit risk, spreads or ratings.

  1. 1Identify what is asked: a definition, a risk type, a rating interpretation or a spread calculation.
  2. 2If it is a risk-type question, ask whether the loss comes from non-payment (credit risk), price change from rates (interest rate risk), difficulty selling (liquidity risk) or early redemption (call risk).
  3. 3For ratings, place the rating on the scale: AAA safest, BBB lowest investment grade, BB and below speculative, D default.
  4. 4For spreads, subtract the risk-free yield of similar maturity from the bond yield. Keep units in percent or basis points.
  5. 5Link direction: higher risk means higher yield and wider spread; downgrade means price falls.
  6. 6Check the options for traps such as treating a rating as a guarantee or as a recommendation.
  7. 7Pick the option that matches the exact wording and sign of the change.

Quickest way: Rating and spread shortcut

When to use it: Use this for direct MCQs on ratings, spreads and risk types when time is short.

  1. Safer rating means lower yield, narrower spread and higher price.
  2. Weaker rating means higher yield, wider spread and lower price.
  3. Spread = bond yield − government yield. Convert 1% to 100 basis points.
  4. Match risk to cause: default = credit, rate move = interest rate, hard to sell = liquidity.
  5. Reject any option saying a rating guarantees repayment.

Common mistakes in Credit Risk and Credit Ratings

  • Treating a credit rating as a guarantee of repayment.

    AAA sounds like a promise of safety.

    Fix: A rating is an opinion on likelihood of timely payment. It can be revised and can be wrong.

  • Thinking a downgrade raises the bond price because yield rises.

    Students see the higher yield and miss the price effect.

    Fix: Yield rises because price falls. Downgrade means wider spread and lower price.

  • Calling BB an investment grade rating.

    BB looks close to BBB.

    Fix: Investment grade ends at BBB. BB and below are speculative grade.

  • Computing spread against a government bond of a different maturity.

    Students use any benchmark yield given.

    Fix: Use the risk-free yield of similar maturity, otherwise the gap includes term differences.

  • Confusing credit risk with interest rate risk.

    Both make bond prices fall.

    Fix: Credit risk comes from the issuer's ability to pay. Interest rate risk comes from changes in market rates.

  • Mixing up percent and basis points in spreads.

    Options give both forms.

    Fix: 1 percentage point = 100 basis points. Convert before comparing.

Worked examples

Example 1

A corporate bond maturing in 5 years yields 9.40%. A 5-year government security yields 7.10%. What is the credit spread in basis points?

Show the solution
  1. Spread = corporate yield − government yield = 9.40% − 7.10%.
  2. 9.40 − 7.10 = 2.30 percentage points.
  3. Convert: 2.30 × 100 = 230 basis points.

Answer: 230 basis points

Example 2

An issuer's bond is downgraded from AA to A by a rating agency. Which is the most likely effect on the bond in the market?

Show the solution
  1. A downgrade signals higher perceived default risk.
  2. Investors demand a higher yield for the added risk.
  3. The credit spread widens.
  4. A higher required yield means the bond price falls.

Answer: The spread widens and the bond price falls.

Exam tips

  • Expect direct questions on the investment grade boundary: BBB is the last investment grade rating.
  • Watch for options that call a rating a guarantee or a recommendation. These are wrong.
  • For direction questions, link downgrade to wider spread, higher yield and lower price in one chain.
  • Read carefully whether the question asks for spread in percent or basis points.
  • Match the scenario to the risk type before looking at the options.

Practice questions from Investing in Fixed Income Securities (NISM XXI-A)

Credit Risk and Credit Ratings 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 and Credit Ratings: frequently asked questions

What is a credit spread in bonds?

It is the extra yield a bond pays over a risk-free government security of similar maturity. It compensates you for taking credit risk. A wider spread means higher perceived risk.

Which agencies rate debt in India?

SEBI-registered credit rating agencies such as CRISIL, ICRA, CARE and India Ratings assess issuers and instruments. Each uses its own letter scale, but the broad structure from AAA to D is similar.

What are the main risks in fixed income investing?

The main ones are credit risk, interest rate risk, reinvestment risk, liquidity risk, call risk and inflation risk. Each has a different cause, so match the cause to the risk in exam questions.

Does a high rating mean I cannot lose money?

No. A high rating means lower likelihood of default in the agency's opinion. Ratings can be downgraded, and prices can still fall from spread widening or rate changes.