Introduction

Default risk is the risk that a bond issuer may fail to make interest or principal payments as scheduled. It is a key factor in fixed-income investments, as it directly impacts the creditworthiness of a borrower.

Investors who purchase government bonds, corporate bonds, or municipal bonds must evaluate default risk before investing. The higher the default risk, the higher the return investors demand to compensate for the potential loss. As a result, bonds with higher default risk offer higher interest rates (yields).

This article explains default risk, its causes, how it affects investments, methods to measure it, and ways to reduce exposure in the Indian financial market.

What Is Default Risk?

Default risk refers to the possibility that a bond issuer (government, corporation, or financial institution) may fail to make timely interest payments or repay the principal amount.

Key Characteristics of Default Risk:

• Higher risk = Higher interest rates to attract investors.
• Credit ratings help assess default probability (AAA being the safest, D indicating default).
• Government bonds have low default risk, while corporate bonds carry varying levels of risk.
• For example, if a corporate bond offers a 10% interest rate, while a government bond offers 6%, the corporate bond likely carries higher default risk.

How to Measure Default Risk?

1. Credit Ratings

Credit rating agencies like CRISIL, ICRA, and CARE Ratings assign ratings based on an issuer’s ability to meet debt obligations.

For example, Government of India bonds have AAA ratings, while small company bonds may be rated BBB or lower due to default risk.

2. Bond Yield Spreads

Higher yields indicate higher default risk. Investors compare corporate bond yields with government bond yields (which have no default risk) to assess risk.

Formula to Calculate Yield Spread:

Yield Spread=Corporate Bond Yield−Government Bond Yield

For example:

• 10-year Government Bond Yield = 6%
• Corporate Bond Yield = 9%
• Yield Spread = 9% - 6% = 3%
• A wider yield spread means the corporate bond has a higher default risk.

3. Probability of Default (PD) and Loss Given Default (LGD)

• Probability of Default (PD): Measures the likelihood that an issuer will default within a time frame.
• Loss Given Default (LGD): Estimates how much investors lose if default occurs.
• For example, if a company has a 10% default probability and LGD of 60%, investors should demand higher returns to compensate for risk.

How to Reduce Exposure to Default Risk?

1. Invest in Government and PSU Bonds

• Government bonds (G-Secs) have zero default risk.
• PSU bonds are safer than private company bonds.

2. Diversify Your Bond Portfolio

• Avoid putting all money in a single corporate bond.
• Diversify across government bonds, AAA-rated corporate bonds, and municipal bonds.

3. Check Credit Ratings Before Investing

• Invest in AAA or AA-rated bonds for lower default risk.
• Avoid junk bonds (BB or lower) unless willing to take high risks.

4. Monitor Financial Health of Issuer

• Analyze debt-to-equity ratio, cash flow, and earnings reports before investing.

5. Consider Debt Mutual Funds

• Debt mutual funds provide diversified exposure to bonds, reducing individual bond risk.
• For example, corporate bond funds invest in AAA-rated securities, lowering default risk.

Conclusion

Default risk is one of the most important factors in bond investing, as it determines whether an issuer can fulfill its debt obligations. Investors must analyze credit ratings, bond yields, and financial strength of issuers to manage risk effectively.

By diversifying across government bonds, AAA-rated corporate bonds, and debt mutual funds, investors can reduce exposure to default risk while still earning steady returns.

References used: 

• https://www.investopedia.com/terms/d/defaultrisk.asp
• https://www.investopedia.com/ask/answers/what-does-investment-grade-mean/

Cover image reference: https://img.freepik.com/premium-photo/business-risk-3d-rendering_519469-3231.jpg