Final answer:
The risk that a company cannot meet its financial obligations when due is known as credit risk or default risk. Investors can reduce this by diversifying their bond portfolios. Banks plan for some loan defaults but can be hit hard by unexpected increases in default rates.
Step-by-step explanation:
The risk that a company will not be able to pay its obligations when they come due is referred to as credit risk or default risk. A bond issuer that has secured debt through corporate bonds is expected to make certain payments over time. If the issuer, such as a corporation, fails to make these payments, this could lead to bankruptcy, where the company's assets are sold off to pay bondholders as much as possible. To mitigate such risks, investors often diversify their portfolios by purchasing bonds from a variety of companies. This diversification strategy ensures that even if some companies default on their bond payments, not all investments will be affected, thereby reducing overall portfolio risk.
Banks also factor in the eventuality of some loans not being repaid. They include a buffer in their financial planning to accommodate the loss from loan defaults. However, when a significant unanticipated increase in loan defaults occurs, particularly during economic downturns, it can lead to substantial financial strain, potentially diminishing the bank's net worth.