A higher default risk generally corresponds with higher interest rates, and issuers of bonds that carry higher default risk will often find it difficult to access to capital markets (which may affect funding potential).
The Bottom Line
Lenders and investors use various measures to determine the likelihood than an individual, a company, or a government will default on debts. The greater the odds of default, the more that the lender or investor will expect be compensated in terms of higher interest rates.
Equities are generally considered the riskiest class of assets. Dividends aside, they offer no guarantees, and investors' money is subject to the successes and failures of private businesses in a fiercely competitive marketplace. Equity investing involves buying stock in a private company or group of companies.
Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments.
Historically, investment-grade bonds witness a low default rate compared to non-investment grade bonds. For example, S&P Global reported that the highest one-year default rate for AAA, AA, A, and BBB-rated bonds (investment-grade bonds) were 0%, 0.38%, 0.39%, and 1.02%, respectively.
Bond ratings summarize the risk of default for an individual bond. The safest bonds—AAA, AA, A, and BBB—have a one-year probability of default that is less than 0.1 percent. 4 Speculative-grade bonds—BB, B, and CCC—are considerably riskier.
Stocks are generally considered to be riskier than bonds, cash alternatives and commodities. While both bonds and cash alternatives offer the investor a promised rate of return, stocks offer no such guarantee.
Given the numerous reasons a company's business can decline, stocks are typically riskier than bonds. However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation.
Investors can use CDS contracts to hedge against the risk of default on specific bonds or portfolios of bonds. Portfolio Diversification: CDS allow investors to diversify their portfolios by providing exposure to credit markets without directly owning the underlying bonds.
Highest credit quality
'AAA' ratings denote the lowest expectation of default risk. They are assigned only in cases of exceptionally strong capacity for payment of financial commitments.
There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid. With most bonds, you'll get regular interest payments while you hold the bond. Most bonds have a fixed interest rate. Or, a fee you get to lend it.…
Credit Risk
Defaults can occur on mortgages, credit cards, and fixed income securities. Failure to meet obligational contracts can also occur in areas such as derivatives and guarantees provided.
The lower the default risk, the lower the required interest rate; higher default risks come with higher interest rates. The opportunity cost of accepting lower default risk, therefore, is higher interest income. Credit spread risk is an important but often ignored component of income investing.
Default risk can be affected by many factors, such as recessions, inflations, and company management. Economic Factors: Economic recessions or downturns can increase default risk as companies struggle to generate sufficient revenue to meet their debt obligations.
Certificate of deposit (CD)
Like a savings account, a certificate of deposit (CD) is often a safe place to keep your money. One big difference between a savings account and a CD is that a CD typically locks up your money for a set term. If you withdraw the cash early, you'll be charged a penalty.
Because Treasuries are backed by the "full faith and credit" of the U.S. government, they're considered one of the safest investments.
-- AAA corporate bonds almost never default (99%). -- But AAA CMBS bonds have defaulted in the last few cycles.
Treasury bonds, notes, and bills have no default risk since the U.S. government guarantees them. Investors will receive the bond's face value if they hold it to maturity.
'BBB' ratings indicate that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate, but adverse business or economic conditions are more likely to impair this capacity.