Default Risk Premium
What is 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.
Default Risk Premium: a worked example
A ten-year government bond yields 3.5%, while Vantor Freight, a low-rated shipper, must offer 8.2% on its own ten-year bond. The default risk premium is 8.2 - 3.5 = 4.7 percentage points, worth $470 a year of extra coupon on $10,000 of face value. Whether that compensates the lender depends on expected losses. If Vantor carries a 6% chance of defaulting in a given year and lenders recover 40 cents on the dollar, the expected annual loss is 0.06 x (1 - 0.40) = 3.6 percentage points. The premium exceeds expected losses by 1.1 points, and that remainder is the reward for bearing uncertainty rather than the average outcome.
The mistake students make with default risk premium
The tempting error is reading the premium as extra return you will actually earn. Those 4.7 points are extra promised yield, collected only while the issuer keeps paying; net out the 3.6 points of expected default loss and only 1.1 points survive, and on a weaker credit the expected return can land below the government bond's. A second slip is comparing bonds of different maturities, which quietly folds a maturity premium into the figure, so match maturities before subtracting. The raw corporate-minus-government spread also pays for illiquidity, so treating the whole spread as credit risk overstates it.
Default Risk Premium questions
How do you calculate a default risk premium?
The default risk premium is calculated by subtracting the yield on a risk-free government bond from the yield on the risky bond, using the same maturity for both. If a five-year corporate bond yields 7.0% and a five-year government bond yields 3.0%, the premium is 4.0 percentage points. Matching maturity matters, because a longer bond carries a maturity premium that has nothing to do with credit quality.
Why do junk bonds pay higher interest than government bonds?
Junk bonds pay more because buyers demand compensation for a real chance of not being repaid in full. A lower credit rating signals thinner cash flows and more debt ranking ahead of you in bankruptcy, so the default risk premium widens. Weak business conditions widen it further, since defaults cluster exactly when investors most want their money back. Part of the extra yield also pays for illiquidity, because these bonds are harder to sell quickly.
What is the difference between a default risk premium and a credit spread?
A credit spread is the whole yield gap between a corporate bond and a comparable government bond, while the default risk premium is only the slice of that gap compensating for possible non-payment. The rest of the spread pays for liquidity, tax treatment and, if maturities do not match, term risk. Analysts often use the two words loosely, but the distinction matters when a bond is safe yet rarely traded.
Formula / Example
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated