Default risk

Definition

Default risk is the possibility that a borrower will be unable to make the required payments on their debt obligations, leading to a failure to repay principal or interest. This risk is crucial in assessing the overall creditworthiness of borrowers, especially in the context of fixed-income investments like bonds, where it directly influences pricing and yields. A higher default risk typically results in lower bond prices and higher yields to compensate investors for taking on additional risk.

5 Must Know Facts For Your Next Test

1. Default risk is a critical component when determining the credit ratings assigned to bonds, as agencies assess the likelihood of default based on the issuer's financial health.
2. Investors typically demand higher yields on bonds with higher default risk to compensate for the potential loss of income and principal.
3. In addition to company-specific factors, economic conditions, industry health, and interest rate fluctuations can influence default risk.
4. Default risk is not just relevant to corporate bonds; it also applies to government bonds, particularly those issued by countries with unstable economies.
5. Investors can mitigate default risk through diversification in their bond portfolios, spreading investments across various issuers and sectors.

Review Questions

• How does default risk affect bond pricing and investor decisions?
  • Default risk directly impacts bond pricing because investors demand higher yields for bonds perceived as having higher default risks. When a bond issuer is deemed likely to default, its market price typically decreases, as investors want compensation for taking on that increased risk. As a result, understanding default risk helps investors make informed decisions about which bonds to buy based on their desired level of risk and potential return.
• Discuss how credit ratings relate to default risk and the implications for both investors and issuers.
  • Credit ratings serve as an assessment of an issuer's default risk, with higher ratings indicating lower likelihood of default. For investors, these ratings help gauge the relative safety of different bond investments; lower-rated bonds generally offer higher yields but carry greater default risk. For issuers, a lower credit rating can lead to higher borrowing costs and diminished access to capital markets, making it essential for them to maintain strong financial practices.
• Evaluate the broader economic consequences of widespread defaults in corporate bonds due to rising default risk.
  • Widespread defaults in corporate bonds can lead to significant economic repercussions, including increased borrowing costs for companies and a potential credit crunch. This scenario may stifle business investment and expansion, which in turn can result in job losses and reduced consumer spending. Furthermore, a spike in defaults can erode investor confidence in financial markets, triggering broader market instability and potentially leading to a recession as economic activity slows down.

Related terms

Credit Spread: The difference in yield between a bond and a risk-free benchmark bond, reflecting the additional risk associated with the borrower.

Yield to Maturity (YTM): The total return anticipated on a bond if it is held until maturity, accounting for all coupon payments and the difference between purchase price and face value.

Debt-to-Equity Ratio: A financial ratio indicating the relative proportion of a company's debt to its shareholders' equity, used to assess financial leverage and risk.