Default as a Risk Factor


The last of the five risk factors is the “default risk factor,” which is associated with the credit quality of bonds. Instruments of lower credit quality are riskier than those of higher credit quality, thus yielding higher expected returns. Despite the downgrade of U.S. government debt by Standard & Poor’s that occurred in 2011, the market still assigns a higher default risk to corporations over the U.S. government. The default risk factor refers to the additional expected return of corporate bonds over government bonds. Figure 8-11 shows the strong relationship between risk, return and the growth of $1 as the probability of default increases.


Figure 8-11

Step 8Default FactorCreditGovernment BondsCorporate Bonds