Default risk premium
Default Risk Premium
To begin this article I will start with 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. The premium part comes into play when the investor 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.
The 3 Elements
It is important to understand the following concepts regarding bonds. Treasury notes and bonds carry three vital characteristics:
- They are default free
- They are taxable
- They are extremely liquid.
Generally all bonds do not carry these specific features. Bonds issued by corporations or municipalities play by different rules.