Understanding Default Risk Premium: Evaluating Investment Risk and Return

Default Risk Premium

the additional yield earned by bond/security subject to default relative to default-free securities; countercyclical–widen in recession and narrow in expansions

The default risk premium is an additional return that investors demand in compensation for the potential loss of their investment due to the risk of default. It is a measure of the likelihood that a borrower will default on their debt obligations, and it reflects the additional compensation required by investors for taking on such risks.

The default risk premium is typically higher for riskier investments, such as high-yield bonds or lower-rated corporate debt, as these investments carry a higher risk of default. In general, the greater the probability of default, the higher the default risk premium demanded by investors.

Credit ratings agencies such as Moody’s and Standard & Poor’s provide credit ratings for companies and countries, which help investors evaluate the creditworthiness of a potential investment. A company with a high credit rating (such as AAA or AA) typically has a low default risk premium, while a company with a lower credit rating (such as BB or B) will have a higher default risk premium.

Government bonds generally have a low default risk premium due to the creditworthiness of the issuing government. However, even government bonds can have varying levels of default risk premium depending on factors such as economic conditions, political stability, and fiscal policy.

In summary, the default risk premium is an important consideration in assessing the risk and potential return of an investment. Investors demand a higher return for taking on the risk of default, and this additional compensation can reflect the creditworthiness of the borrower as well as broader economic and political factors.

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