The second risk is known as Credit Risk or Risk of Default. It refers to the situation where the borrower fails to honour either one or both of his obligations of paying regular interest and returning the principal on maturity. A bigger threat is that the borrower does not repay the principal. This can happen if the borrower turns bankrupt. This risk can be taken care of by investing in paper issued by companies with very high Credit Rating.
The probability of a borrower with very high Credit Rating defaulting is far lesser than that of a borrower with low credit rating. Government paper is the ultimate in safety when it comes to credit risk (hence the description ‘risk free security’). This is because the Government will never default on its obligations. If the Government does not have cash (similar to a company going bankrupt), it can print more money to meet it’s obligations or change the tax laws so as to earn more revenue (neither of which a corporate can do!).
The probability of a borrower with very high Credit Rating defaulting is far lesser than that of a borrower with low credit rating. Government paper is the ultimate in safety when it comes to credit risk (hence the description ‘risk free security’). This is because the Government will never default on its obligations. If the Government does not have cash (similar to a company going bankrupt), it can print more money to meet it’s obligations or change the tax laws so as to earn more revenue (neither of which a corporate can do!).
