Default risk premium
Default Risk Premium
In commencing this article here is 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, Treasury bonds or notes. These are extremely popular investments and are usually rated higher.
Bond Ratings
Bond Ratings are actually an investors "best friend", if you will. In general terms, they aid investors in recognizing strong bonds and of course weak bonds, specifically concerning default risk. In this case, most firms hire outside agencies to rate their debt. Moody's and Standard & Poor's are two popular and prominent bond-rating firms. When rating debt, these two financial giants evaluate the creditworthiness of the issuer by assessing the likelihood of default and more importantly the creditors protection if default should occur. It is also important to understand that bond ratings are concerned with the possibility of default, which means that the strong variable of interest rate risk is left unevaluated. As a result, bond prices are subject to change at any given moment of the markets interest rates.
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.
Who Pays Default Premiums?
Commonly companies who have low grade bonds or people who have poor credit history pay a default premium. Companies will offer higher yields when the rating of the bond is low. As people with inferior credit must pay the bank higher interest rates in order to compensate the bank for the risk they are undertaking in lending the money. Conversely, people with strong credit will pay lower interest rates as a result of the merit of their credit history. This borrower is effectively more trust worthy. All in all, a Default Risk Premium is a financial instrument utilized to counterweigh the degree of risk of an investment.