Question

How is default risk different from default risk premium?Describe two ways an investor can evaluate a bond issuer's risk of default.

Answer 1

Default risk tells the inability of the issuer of the funds  or borrowers in paying back the debt or principal amount, whereas default risk premium is the top-up or additional interest rate over and above the risk free rate, that comes with the risky bonds. A higher level of risk, means higher value of the default risk premium. In contrast to it, default risk is the risk of not paying back the funds  and  a higher default risk leads to the higher default risk premium. Further, default risk is a risk, but default risk premium is the reward to take that risk.

The first way to evaluate the risk of default is the assess the credit rating of the bond issuer. The bond issued, can be of investment grade bond or junk bond. Further, bond can be low risk or high risk bond, depending upon the rating given by the reputed rating agencies.

The second way is to evaluate the risk premium offered on the bond. A higher risk premium upon the bond, will make bond issuers to pay higher return and it can make them default on their promise to pay. So, it is also an important way to assess the default risk of the bond issuers.