What is Default Risk?
How Does Default Risk Work?
Although the definition of default risk may be fairly concrete, measurement of it is not. Many things can influence an issuer's default risk and in varying degrees. Examples include poor or falling cash flow from operations (which is often needed to make the interest and principal payments), rising interest rates (if the bonds are floating-rate notes, rising interest rates increase the required interest payments), or changes in the nature of the marketplace that would adversely affect the issuer (such as a change in technology, an increase in competitors, or regulatory changes). The default risk associated with foreign bonds also includes the home country's sociopolitical situation and the stability and regulatory activity of its government.
Ratings agencies like Moody's and Standard & Poor's research and analyze bond offerings in an effort to measure an issuer's default risk on a particular security. The results of their work are credit ratings that investors can track and compare with other issuers.
S&P's ratings vary from AAA (the most secure) to D, which means the issuer is already in default. Moody's ratings go from Aaa to C. Only bonds rated BBB or better are considered 'investment grade.' Anything below BBB- or Baa3 is considered 'junk.'
Why Does Default Risk Matter?
Default risk is perhaps one of the most fundamental types of risk. After all, it represents the chance the investor will lose his or her investment. All bonds, except for those issued by the U.S. government, carry some level of default risk. This is one reason corporate bonds almost always have higher coupons than government bonds.