Default Risk [PD]

Default risk, also called credit risk, is the probability that a borrower will fail to make required payments on debt obligations. It’s the primary risk in lending and bond investing. Default can mean missing payments, bankruptcy, or debt restructuring. Historical corporate default rates average 1.5% annually for investment grade and 4% for high-yield, but can spike during recessions. For example, in 2009, high-yield default rates reached 13%. Default risk is compensated through higher interest rates – a company with high default risk might pay 10% interest while a low-risk borrower pays 4%. Factors affecting default risk include leverage ratios, cash flow stability, industry conditions, and economic cycles. Credit default swaps (CDS) allow investors to buy protection against default. Recovery rates (amount recovered after default) vary widely, averaging 40% for senior secured bonds but near zero for subordinated debt. Managing default risk involves diversification, credit analysis, and monitoring rating changes.