Assess credit risk  – The Hindu

The promise of higher returns can be misleading. Investors need to be careful

The promise of higher returns can be misleading. Investors need to be careful

Rajesh asks his colleague Parag to lend him 400. Rajesh assures Parag that he will return the amount in the evening, after he has a chance to withdraw it from the ATM.

Rajesh only had a 2,000 banknote and needed change for his lunch, etc. They have been friends for years and this was a small thing. Even if Rajesh had said, “I’ll pay you tomorrow,” Parag wouldn’t have worried.

In this case, the credit risk for Parag, i.e. the probability that Rajesh would not repay the amount, was insignificant. Even if Rajesh had forgotten, Parag wouldn’t have cared.

tenure, risk

Suppose Rajesh had said that he would pay it back after three months, Parag would have thought that was strange. He wouldn’t have turned down the request to lend the money to Rajesh, but a question would have popped into his head; this would have implied that there was a credit risk. Even so, Parag may still have lent the money. The first principle of credit risk is that as maturity increases, credit risk increases.

Familiarity with borrower

Now suppose the employee of a neighboring office had asked Parag for 400. Unless Parag knew that person, he might have declined or been a little reluctant to borrow.

The next factor to keep in mind is the reputation of the borrower. If the borrower is unknown, there is a greater risk.

The above examples were of money being lent without any form of security. Money is often lent against a security, for example when we lend money to someone by asking the borrower some kind of security. Here we evaluate, in addition to the borrower, the quality of the item (asset) that is given as security; when we lend someone money against gold, we want to judge the quality/purity of the gold.

There are several factors that we look at before lending money. The reason we do this is because we want to make sure that the money lent is repaid to us on time. And if interest has to be paid to us, we want it to be paid on time. All these checks are intended to mitigate credit risk.

Just as we lend money to private individuals, we also lend to banks; when we deposit money in a savings bank account, invest in fixed deposits, etc., we are actually lending it to them. When we invest in bonds, bonds, etc., we are actually lending money to the institution that issues them. It is important to evaluate the risk of that loan. We need to consider how safe the principal is and how certain the timely payment of interest will be. This can be verified by reading the offer document in detail. Get details of the institution, its past performance, what its ratings are – there are rating agencies that assess the safety of principal and timely payment of interest – whether the loan amount is secured against certain assets and the quality of those assets .

I am often asked about investing in a particular type of bond or bond because they yield about a percentage point or two more. “My standard answer is: how much do you invest and how much more do you make in money?”

Let’s understand this with an example. Suppose a person wants to invest ₹10,000 in a bond that yields 2% more annually than a fixed bank deposit. Depositing in the bank is always safe. The higher return in real money terms means it’s ₹200 more per year.

The investor has to decide whether it is worth taking that extra risk for ₹200 more per year. Also liquidity, ie the ease of cashing in the case of a bond, is either not possible or cumbersome.

A credit risk is the risk of default on a debt that can arise from a borrower’s failure to make the required payments. So often, tempted by the promise of higher interest income, we take unnecessary credit risks. Always remember: the higher the interest rate, the greater the risk.

(The writer is a financial planner and author of Yogic Wealth)

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