Credit Risk
It is the risk of non-payment of interest and principal by the security issuer. Government securities are said to be risk free securities. There is inverse relation between the price of securities and level of credit risk. If market perceives such risk increased in the securities after purchase, the investor can sell it at the reduced price only. On the basis of probability of default, there is a practice of rating the debt securities by various rating agencies. If the issuers default, they file for creditor protection under bankruptcy laws. This culminates either in liquidation of the firm (sale entirely to another firm or sale in piecemeal) or in reorganization (merger or any other arrangement). In both the cases, security holders may lose part of principal and accrued interest due to lost goodwill and litigation costs. The credit policy should specify what rated securities it wants to hold in the portfolio. If unrated, whether it buys or not. Since risk is overpriced during recession and under-priced during boom, banks prefer buying medium grade and high-grade securities during recession and boom respectively. Normally, banks buy investment rated securities only.
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