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What is meant by Default Risk and Default Premium?
What is Default Risk?
Both corporate and governments issue bonds for the investors, but there is a clear difference between them. Government bonds are free from the chances of default. That is, it is believed that government bonds will never fail to pay the interest rates and the principal as and when required.
On the other hand, corporate bonds are not free from the chances of default as the investment made by the corporate are more risky assets. Corporate bonds therefore have the chances of a default if they go bankrupt or face other issues.
The risk of corporate bonds going bankrupt and thereby having a default is known as default risk. It is the risk associated with bonds whereby, the borrowers fail to pay the pre-determined amount of interest along with the principal at the time of maturity.
What is Default Premium?
When the corporate bonds have the chances of defaulting, they must do something to lure the investors to buy their bonds instead of buying only government bonds. The lure comes as a default premium along with the bonds.
The default premium is a premium amount of money associated with the bond that is paid extra along with the interest and principal. The sole aim of default premium is to cover any uncertain conditions in the future where the borrowers go bankrupt.
It is to be noted that all corporate bonds do not fail to pay the returns and principal as pre-determined while issuing the bonds. But, it is in comparison with government bonds' performance that default risk and default premium become prevalent in general.
There are other takeaways available with corporate bonds. Usually, the return rate of corporate bonds is palpably higher than government bonds. So, the yield of corporate bonds is measurably higher than government bonds. Therefore, investors seeking higher returns and willing to take the risk should approach corporate bonds instead of government ones.
On the other hand, investors with low appetites and those who don't mind low returns should go for government bonds. These bonds usually never fail to pay the returns and hence are a good option for people who want low volatility and bankruptcy.
Points to Note
It is important to read the terms and conditions of a bond before buying it. Some companies may offer bankruptcy protection while others may not provide it.
Default risk is negligible in case of government bonds. They, however, offer lower returns too.
All corporate bonds do not fail and hence default premium comes as a double reward in the case of corporate bonds.
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