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Default Risk

Default risk is the chance that a borrower will fail to make required interest or principal payments on a debt, leaving the lender or bondholder with a loss.

What Is Default Risk?

Default risk is the possibility that a borrower will be unable or unwilling to meet the terms of a debt. In practice, this means missing scheduled interest payments, failing to repay principal when it is due, or breaching conditions set out in a loan agreement. It applies to government bonds, corporate bonds, bank loans, mortgages, and other forms of credit. Investors who lend money accept this risk in exchange for interest income.

Default risk is one part of credit risk, which is the broader concern that a borrower's financial condition will weaken and reduce the value of its debt.

How Default Risk Is Assessed

Lenders and investors usually judge default risk by examining a borrower's ability to generate cash, its existing debt load, and its history of meeting obligations. Independent credit rating agencies publish letter-grade ratings that summarize this judgment, with the highest grades signaling the lowest perceived risk. Analysts also look at measures such as the debt-to-equity ratio and the interest coverage ratio, which compare a company's earnings or equity with its debt and interest costs.

Bonds with higher default risk typically offer a higher yield to compensate investors. The gap between a riskier bond's yield and that of a low-risk benchmark, such as a government bond, is called the credit spread.

Why It Matters to Investors

When a default occurs, bondholders may recover only part of their investment, and the recovery amount can vary widely depending on the borrower's remaining assets and the priority of the debt. Holders of senior secured debt generally have a stronger claim in bankruptcy than unsecured creditors or shareholders.

Default risk is one reason investors diversify across issuers and pay attention to credit quality. Holding a single high-yield bond exposes an investor to the full loss if that issuer defaults, while a broader mix spreads that exposure. Understanding default risk helps explain why one bond pays a higher yield than another and what that extra income may be compensating for.

Updated October 16, 2026. For general education only; not financial, tax or legal advice.

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Related Terms

Credit Risk

Credit risk is the possibility that a borrower or counterparty will fail to repay a loan or meet its contractual obligations, causing a financial loss to the lender or investor.

Debt-to-Equity Ratio (D/E)

The debt-to-equity ratio compares a company's total liabilities to its shareholders' equity, showing how much of its funding comes from borrowing versus from owners' capital.

Interest Coverage Ratio (ICR)

An interest coverage ratio measures how many times a company's operating earnings can cover its interest expense during a period, calculated by dividing EBIT by interest expense.

Yield

Yield is the annual income an investment pays out, such as interest or dividends, expressed as a percentage of its current market price or face value.

Credit Spread

A credit spread is an options strategy that involves selling one option and buying a cheaper one on the same underlying, receiving a net credit upfront; the term also describes bond yield gaps.

Bond Yield

A bond yield is the annual return an investor earns from holding a bond, expressed as a percentage of its price, reflecting coupon income and any gain or loss relative to the amount paid.

Credit Rating

A credit rating is an independent assessment, usually expressed as a letter grade, of how likely a borrower is to repay its debt in full and on time.

Bankruptcy

A legal process in which a person or business unable to repay its debts seeks court protection, and its assets are either sold or its debts reorganized under the rules of the bankruptcy law.