Default Risk
What Is Default Risk?
Default risk is the possibility that a borrower will fail to meet their financial obligations, such as making interest payments or repaying principal on a loan or bond.
Default risk applies to many types of debt, including personal loans, corporate bonds, and government securities.
Why It Matters
Default risk is one of the most important factors investors consider when lending money or purchasing bonds. Higher default risk typically results in higher interest rates because lenders require greater compensation for taking on additional risk.
Managing default risk is essential for building a balanced investment portfolio.
How Default Risk Works
Default risk depends on several factors:
- financial health of the borrower
- economic conditions
- credit ratings
- industry stability
Borrowers with weaker financial positions usually face higher borrowing costs.
Example
A bond issued by a financially struggling company may carry a higher default risk than a bond issued by the U.S. government.
Default Risk vs Credit Risk
- Credit risk refers broadly to the possibility of borrower failure.
- Default risk specifically refers to the failure to make required payments.
FAQs About Default Risk
Do government bonds have default risk?
They generally have very low default risk.
Why do risky bonds offer higher yields?
Investors demand higher returns for higher risk.
Can default risk change over time?
Yes, economic conditions and financial health influence risk levels.
Related Terms
