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Default Risk

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Default risk is the risk born by a creditor that a debtor will default. Default risk is also called credit risk or financial risk. Creditors are compensated for lending to debtors with higher levels of default risk by the potential for higher rates of return. Consider the corporate bond as a form of debt with inherent default risk. Companies with higher default risk borrow at higher rates. An AAA rated company can issue bonds at the lowest interest rate given its low default risk. Companies that may have too little cash flow to satisfy their current (or future) debt service obligations have a high default risk. When bonds issued by such companies are rated below investment grade, the bonds are called junk bonds. When the default risk of a company changes, the market price of its bonds will shift to adjust compensation to current bondholders.



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