AP MacroeconomicsMoney, Banking & Finance
Default Risk Premium
The default risk premium is the extra yield a risky bond pays over a risk-free bond to compensate investors for the chance the issuer defaults.
It is the credit-risk slice of a bond's interest rate, found by subtracting the risk-free Treasury yield from the risky bond's yield (controlling for maturity). Lower credit ratings and weaker economic conditions raise the premium; this is why junk bonds yield far more than Treasuries. It is one component of the total interest rate alongside the real rate, inflation premium, liquidity premium, and maturity premium.
Formula / Example
Default risk premium = Risky bond yield − Risk-free yield (same maturity)