Default RiskPD
Default risk is the chance that a borrower fails to make interest or principal payments on time. Credit ratings and credit spreads are the most common ways markets express it.
Lending money always carries one basic risk: the borrower might not pay you back. For bonds, that risk has a name — default risk — and it is priced into every yield. Governments of large economies are seen as very safe; many companies are less so. This entry explains what default is, how ratings and yields reflect default risk, and what investors can do about it.
- Category
- Bonds and Interest Rates
- Reading time
- 3 min
- Also called
- Probability of default, Risk of default, Issuer risk
- Updated
Default risk in plain words
A default is a failure by an issuer to pay principal or interest when due, or to meet other obligations.1 Default risk is the chance that this happens.
Bonds believed to carry higher default risk receive lower ratings and are typically issued at higher yields to compensate investors.2 See Credit Spread.
How to assess default risk, step by step
Check the rating
Investment grade is BBB/Baa and above; high yield is BB/Ba and below.3
Check the spread
Extra yield over government bonds shows the market’s view.
Check the finances
Debt levels, cash flow and interest cover. See Free Cash Flow.
Check upcoming maturities
Large debts due soon raise refinancing risk. See Maturity Wall.
Diversify
Spread credit risk across many issuers. See Diversification.
Match risk to purpose
Money you need soon belongs in the safest bonds.
Worked examples
Example 1 — Yield as compensation
CompensationA government bond yields 4%. A BB-rated company’s bond of similar maturity yields 7%.
| Extra yield | 3 percentage points |
The extra yield is the price investors demand for the higher risk of default.
Example 2 — What a default does
DefaultAn investor holds $10,000 of a company’s bonds. The company defaults and creditors later recover 40%.
| Recovered | $4,000 |
| Loss | $6,000 |
Losses depend on how much is recovered after default. See Loss Given Default.
Example 3 — Diversification
SpreadA portfolio holds 50 high-yield bonds of 2% each. Two default with 40% recovery.
| Portfolio loss from defaults | 2 × 2% × 60% = 2.4% |
Spreading across issuers keeps any single default from doing serious damage.
Rating categories
| Aspect | Ratings (S&P/Fitch · Moody’s) | Typical yield |
|---|---|---|
| Investment grade | BBB and above · Baa and above | Lower |
| High yield (junk) | BB and below · Ba and below | Higher |
| In default | Lowest categories | Prices reflect expected recovery |
| Major governments | Often top ratings | Benchmark for others |
Why default risk matters
Bond selection
Is the extra yield worth the risk?
Portfolio safety
Safer bonds for money you will need. See Portfolio Allocation.
Market stress
Rising default fears hit high-yield bonds and stocks. See Recession.
Counterparties
The same idea applies to brokers and exchanges. See Counterparty Risk.
Advantages and disadvantages
Advantages
- Ratings give a quick, standard view of risk.
- Higher risk is paid for with higher yields.
- Diversification reduces the impact of single defaults.
Disadvantages
- Ratings can lag reality.
- Defaults cluster in recessions.
- Recoveries are uncertain.
- High yields can tempt investors into too much risk.
Going deeper
Read as far as you need. Each level builds on the one before it.
Risk and return
Beginner
More risk usually means investors demand a higher return. Junk bonds pay more because more of them fail.
Rating changes
Intermediate
A downgrade from investment grade to high yield can force some investors to sell, pushing prices down sharply. See Fallen Angels and Rising Stars.
Expected loss
Advanced
Expected loss ≈ probability of default × loss given default × exposure. It links default risk to what investors actually stand to lose. See Exposure at Default.
Common mistakes
Chasing yield
High yields usually mean high default risk.
Concentrating in one issuer
Diversify credit exposure.
Relying only on ratings
Check finances and spreads too.
Ignoring recessions
Defaults rise in downturns.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Default risk is the chance a borrower fails to pay on time.
- Ratings and credit spreads express it.
- Investment grade: BBB/Baa and above; high yield below.
- Losses depend on recovery after default.
- Diversification limits the damage of single defaults.
Frequently asked questions
Can government bonds default?
What happens when a company defaults?
Are junk bonds always bad?
Further learning
- Credit Spread
How markets price default risk.
- Yield to Maturity
What the yield includes.
- Recession
When defaults rise.
- Diversification
Spreading credit risk.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Investor.gov (SEC). Default (glossary) (opens in a new tab) Checked .
- Investor.gov (SEC). High-Yield Bond or Junk Bond (glossary) (opens in a new tab) Checked .
- Investor.gov (SEC). Investment-Grade Bond (glossary) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.