Default Risk Vs. Spread Risk

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Few investments are considered safer than U.S. Treasury bonds. Buying corporate bonds offers a greater risk of default, which corporations compensate for by offering a greater return on investment. Default is when a bond issuer fails to pay off the bond. The greater the spread — the difference between Treasury bonds and other bond issues — the greater the risk of default.

Default Risk

Bond investors don't have to guess at how much they risk by investing in a particular bond series. The bond market has developed equations for calculating default risk, based on several factors: the probability of default; how soon a default might happen; how much of the bond debt would go unpaid; the chance of recovery; and how much a default would hurt the bondholder. Investors can use this information to select investments based on their own tolerance for risk.

Spread Risk

Treasury bonds have a low rate of interest compared to many others because they're considered zero risk — completely safe. Credit spread is the difference in yield between a corporate bond and a Treasury bond. The spread reflects the greater risk that buyers assume when they buy corporate bonds; the greater the spread, the greater the spread risk. AAA-rated bonds are considered extremely safe, for example, so the spread and the risk are lower than a BB or a junk bond.

Relationship

The default risk influences the credit spread: The greater the default risk, the less safe the bond, which means a better yield for investors if they do pay off. Default risk isn't the only factor involved in determining the spread, however: During recessions, the spread between the safest corporate bonds and riskier offerings tends to shrink, even if the companies involved are doing well. Economist John Krainer says online that spread risk is also influenced by taxes on non-government bonds, and the general lack of liquidity in the bond market.

Considerations

Spread risk can also reflect bond ratings suddenly downgrading a company's creditworthiness because of bankruptcy or a change in the industry, which makes the bond riskier if the company hasn't defaulted. Outside of a massive financial catastrophe, there's usually little correlation between one company's risk and another, unless they're affiliated or in the same industry. For that reason, investors can reduce spread risk not only by picking safe investments, but also by picking diverse companies from many different fields.

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