Default risk premium

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Default Risk Premium

In commencing this article it would only prove appropriate to examine 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 market flux. Here is a look at Moody's and Standard & Poor's ratings:

Rating Classes

High Grade Medium Grade Low Grade Very Low Grade
Moody's Aaa Aa A Baa Ba B Caa Ca C D
Standard & Poor's AAA AA A BBB BB B CCC CC C D

(Low Grade and Very Low Grade (Low Quality) are sometimes referred to as "Junk" bonds.)

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.

When Default Occurs

Bond credit is directly related to the issuer's financial ability. Therefore, if a business suffers large operating losses the bonds, as a result, may drop into the junk bond status. Default or the downgrade of a firm/bond is also possible when a firms liabilities exceeds its assets thus delving the firm farther into debt. When a firm is downgraded it will inevitably impact the bondholders since the timely payments will have failed to be met. Bonds that were initially rated at an investment grade that drop to the degree of a junk bond status are referred to as, "fallen angels." When default occurs it consequently leaves the investors of that bond with a, sometimes, substantial loss.

Debt Variables

There are numerous methods of protecting bondholders. Here are a few:

Securities Description
Collateral * Securities that have been pledged as a form "collateral" or a security for payment of debt.
Mortagages * Securities that are protected by a mortgage on any real property of the borrower; which is commonly real estate such as land or buildings.
Seniority * Hierarchy over other lenders concerning the preference of debt, which results in the subordination of others. If default occurs, subordinated debt holders must select another specifically listed creditor. In most cases, once the selected creditor is compensated, the lender in return will be paid off.