"Default risk premium" is the added fee that a lender receives for the perceived chance that the borrower will not pay back the loan. This is seen mainly in the bond market, where firms with a greater chance of default pay more interest on a bond than safer, more stable companies pay. This can be compared to a mortgage loan, on which a bank charges higher interest to a customer with a worse credit history.
Each bond that is sold is priced according to its perceived risk. Examples of risks are maturity risk, liquidity risk and default risk. Each type of risk increases the chances that the bond will not pay back the expected return.
Because investors take on these risks, they are compensated for that. The greater the perceived risk, the more the bond will pay back.
Default risk premium gives companies greater incentive to not default on their debt, and it provides a market for them to raise capital. Without a default risk premium, investors would not give their money to firms they thought had a chance of defaulting. Also, by never defaulting on its debt, a firm decreases its perceived default risk and lowers its future cost of raising capital.
Credit Rating Agencies
There are three main credit rating agencies in the United States: Standard and Poor’s, Moody’s, and Fitch. A credit agency rates the risk of each bond. As a result, the greater the default risk, the worse the bonds' grade will be.
The amount of interest the issuing firm will pay on a bond depends on its rating. As a result, firms try to get the highest grade possible.
Bonds rated BBB- or higher are considered investment grade. These bonds are considered safe investments, and their perceived risk of default is very low. Thus, the default risk premium these bonds pay is almost nothing. Financial institutions such as banks are allowed to invest only in investment-grade bonds. As a result, it is very important for issuing firms to get at least an investment grade in order to be exposed to the largest market.
Bonds rated lower than investment grade are called speculative grade, or junk bonds. These bonds have the highest perceived risk of default, and thus they pay the highest yield. Investors who like high-risk, high-return securities invest in junk bonds.