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Another important risk associated with bonds is default risk. If the issuer defaults, investors receive less than the promised return on the bond. Therefore, investors need to assess a bond’s default risk before making a purchase. Recall from Chapter 1 that the quoted interest rate includes a default risk premium—the greater the default risk, the higher the bond’s yield to maturity. The default risk on Treasury securities is zero, but default risk can be substantial for corporate and municipal bonds.

Suppose two bonds have the same promised cash flows, coupon rate, maturity, liquidity, and inflation exposure, but one bond has more default risk than the other. Investors will naturally pay less for the bond with the greater chance of default. As a result, bonds with higher default risk will have higher interest rates: rd
r*  IP  DRP  LP  MRP.
If its default risk changes, this will affect the price of a bond. For example, if the default risk of the MicroDrive bonds increases, the bonds’ price will fall and the yield to maturity (YTM
rd) will increase.
In this section we consider some issues related to default risk. First, we show that corporations can influence the default risk of their bonds by changing the type of bonds they issue. Second we discuss bond ratings, which are used to measure default risk. Third, we describe the “junk bond market,” which is the market for bonds with a relatively high probability of default. Finally, we consider bankruptcy and reorganization, which affect how much an investor will recover if a default occurs.

Taken From : Five-Minute MBA – Corporate Finance

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