Assess credit risk 

Rajesh requests 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 currency note 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 will pay you tomorrow,” Parag would not have been concerned.

In this case, the credit risk to Parag, i.e., the chance that Rajesh would not repay the amount, was insignificant. Even if Rajesh had forgotten about it, Parag would not have cared.

Tenure, risk

Suppose Rajesh had said that he would repay it after three months, Parag would have found it weird. He would not have declined the request to lend the money to Rajesh but a question would have arisen in his mind; this would have implied that there was a credit risk. Yet Parag may have still lent the money. The first principle of credit risk is, as the tenure increases, the credit risk increases.

Familiarity with borrower

Now, suppose the peon of a neighboring office had asked Parag for ₹400. Unless Parag knew that peon, he may have refused or would have been a little reluctant to lend.

The next factor to keep in mind is the familiarity of the borrower. If the borrower is not known, there is a greater risk.

The above examples were of money being lent without any kind of security. Many a time, money is lent against a security, for example, when we lend money to someone by asking from the borrower some kind of security. Here, apart from the borrower, we also evaluate the quality of the item (asset) being given as security; if we lend money to someone against gold, we want to evaluate the quality/purity of the gold.

There are several factors we look into before lending money. The reason we do this is because we want to be assured that money that has been lent is paid back to us, and on time. Also, if there is any interest to be paid to us, then we would like the same to be paid as well, and on time. All these checks are to mitigate the credit risk.

Just as we lend money to 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, debentures, etc., we are actually lending money to the institution that issues them. It is important to evaluate the risk associated with that lending. We must verify how safe the principal is and how assured 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 rate the safety of principal and timely payment of interest – whether the amount borrowed is secured against some assets and what the quality of those assets are.

Many times I get questioned about investing in a particular kind of bond or debenture because they are yielding about a percentage point or two more. “My standard reply is, how much are you investing and how much more you will earn in money terms?”

Let us understand this with an example. Assume an individual wants to invest ₹10,000 in a bond which is returning 2% yearly more than bank fixed deposit. Deposit in bank is always safe. The higher return in real money terms means it is ₹200 more a year.

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

A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. So, many a time, lured by the promise of higher interest earnings, we end up taking unnecessary credit risks. Always remember, the higher the rate of interest, the greater the risk.

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