Default risk premium

Eduzendium article

Default Risk Premium

In commencing this article I will provide the "textbook definition" of a Default Risk Premium: "The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default".

All investors must always consider the possibility of credit risk or in other words, default. Investors are essentially risk takers since they are (and should be) equipped with the understanding of this possibility of default. A premium is then introduced primarily to protect the investor who recognizes that issuers may or may not make all the promised payments; therefore, a higher yield is acquired in order to compensate for the risk that is assumed. A common example of a bond that is more susceptible to default is known as a junk bond. This bond is rated at or lower than 'BB' and is considered a high risk investment due to the unlikelihood of meeting the timely payments. Fortunately, there are more secure investments such as, a Treasury bonds or notes. These are extremely popular investments.

The 3 Elements

It is important to understand the following concepts regarding bonds. Treasury notes and bonds carry three vital characteristics:

1. They are default free
2. They are taxable
3. They are extremely liquid.

Generally all bonds do not carry these specific features. Bonds issued by corporations or municipalities play by different rules.

In returning to the topic at hand, Default Risk Premium is fundamentally exactly what it says it is... a risk premium. Much to the similarity of an employee receiving what is known as a, "hazard pay" for working a perilous job, a Default Risk Premium serves the same function. The hazard pay acts as a compensation for the risks the employee will undertake while working. Likewise, a risky investment must offer an investor a premium, to compensate for the increased likelihood of failing to meet timely payments. The premium andthe opportunity of receiving a large return will provide the dicey investment with more merit or value of the identified risk.