Default Risk

Default risk (also called credit risk) is the possibility that a bond issuer will be unable or unwilling to meet its contractual obligations — missing coupon payments, failing to repay principal at maturity, or violating covenants in the bond indenture. Default risk varies enormously across the bond spectrum: U.S. Treasury bonds have essentially zero default risk (backed by the government's taxing power), while high-yield corporate bonds have historically averaged 3-5% annual default rates, spiking to 10%+ during recessions. Rating agencies (S&P, Moody's, Fitch) assess and grade default risk through their credit rating systems. Default risk is the primary driver of credit spreads — the yield premium over Treasuries that investors demand. When a bond does default, investors rarely lose everything; recovery rates average 40-50% for senior unsecured bonds and 60-70% for senior secured bonds. Default risk can be hedged using credit default swaps (CDS), which function like insurance policies against issuer default.