Credit Risk
Definition
Credit risk is the risk that a borrower or bond issuer will fail to make required interest payments or repay the principal on time. This type of risk applies to all debt instruments, from corporate bonds to sovereign debt, and is a key factor in determining the yield and pricing of a bond.
Credit risk is often measured by credit ratings issued by agencies like Moody's, S&P, or Fitch, and it varies widely based on the issuer's financial strength and the terms of the debt.
Why It Matters to Investors
- Determines the likelihood of default, directly affecting expected returns
- Higher credit risk typically comes with higher yields to compensate investors
- Major driver of bond spreads, especially in corporate and emerging market debt
- Credit downgrades can lead to falling bond prices and investor losses
- Can spike during recessions or financial stress, especially in riskier debt markets
The TiltFolio View
Both TiltFolio systems avoid exposure to credit risk by focusing primarily on U.S. Treasury ETFs, which are backed by the full faith and credit of the U.S. government. These instruments carry negligible credit risk and tend to perform better than riskier debt during periods of economic stress.
We view corporate and high-yield bonds as risk assets rather than defensive holdings. During recessions or bear markets, these bonds often decline alongside equities due to rising credit concerns. TiltFolio Adaptive's system is designed to rotate away from such exposures when volatility rises and risk signals deteriorate, while TiltFolio Balanced maintains exposure only to high-quality government bonds.
In our trend-following framework, credit spreads and risk premiums are indirectly captured through price trends and asset performance, helping TiltFolio Adaptive reduce exposure to deteriorating credit conditions without needing to forecast defaults directly.
Real-World Application
• A company with falling profits sees its bonds downgraded to junk status, raising borrowing costs
• Investors demand higher yields on emerging market debt due to sovereign credit concerns
• During a financial crisis, high-yield bond ETFs sell off as defaults rise and liquidity vanishes
• A Treasury ETF holds up or gains value while corporate bonds fall on credit stress