Bond default risk describes the possibility that a creditor will lose money as the result of a bond issuer failing to repay the debt. Governments, businesses and other types of entities borrow money in the form of debt securities that are known as bonds. The creditors or bondholders who purchase these bonds are entitled to receive a return of principal as well as a series of interest payments. A bond goes into default when the issuer fails to make a regularly scheduled interest or principal payment.
Credit rating agencies measure bond default risk by using various techniques to rate the credit quality of bonds. These entities review the finances of bond issuers, comparing the issuer's assets with its outstanding liabilities. Additionally, rating agencies review data related to debt securities a bond issuer sold in the past to see whether the entity has a good history of honoring its obligations. Having reviewed the data, the agencies award a credit score or rating to the newly issued bonds and investors take this information into account before purchasing these securities.
Typically, bond default risk is lower with government issued bonds than other types of debt securities because in many instances, government bonds are general obligation bonds (GOB) which means that interest payments are secured by tax revenues. If a municipality lacks the cash to cover its debt payments then it can simply raise taxes until it has gathered enough money to payoff the debt. Revenue bonds are a type of government issued bond that expose investors to a higher level of risk since these bonds are not backed by taxes. Instead, revenue bond payments are backed by the money that a government entity earns through operating a revenue generating service such as a toll road.
When a company becomes insolvent it may default on its debt obligations although claims on the firm's assets by bondholders have to be addressed before stockholders can attempt to recoup any of their money. Larger more established companies are usually viewed as being more financially stable than start-up firms. Consequently, small firms usually have to pay higher yields on bonds than major companies because if both securities paid the same yield then investors would buy the security with the lowest level of bond default risk.
Investment firms sometimes buy consumer and business loans and convert these debts into mortgage-backed securities. As with government and corporate bonds, mortgage bonds are graded by credit rating agencies. The quality of the underlying loans impacts the mortgage bond's credit rating and investors use this information to gauge the level of bond default risk that is attached to a particular security.