Credit risk is the risk of loss of interest and/or principal stemming from a borrower's failure to repay a loan.

Credit risk has two components:

• Default probability addresses the likelihood that a borrower will default on its debt obligations, without reference to estimated loss.
• Loss severity, also known as Loss Given Default (LGD), measures the portion of value an investor loses. If a bond defaults, investors can still expect to recover a certain percentage of the bond; that percentage is called the recovery rate. Loss severity = 1 - recovery rate

Expected loss = Default probability x Loss severity

The spread refers to the difference between the yield on a specific bond and a comparable maturity (or duration) Treasury. The part of the risk premium representing the default risk is known as the credit spread. If the perception of risk increases for the issuer or for the industry category representing the issuer, the spread may increase or widen. This risk associated with an increasing credit spread is known as the credit spread risk. If there are more concerns about economic security, the spread will widen (implying that the premium for risk increases).

Credit risk could be on account of:

• Downgrade risk: the risk that the issuer will be downgraded, resulting in an increase in the credit spread demanded by the market. The market tends to respond very quickly to news regarding a bond rating decline.

• Market liquidity risk: the widening of the bid-ask spread on an issuer's bonds. The size and the credit quality of the issuer affects market liquidity risk.