Default Risk
The probability that a borrower will fail to make scheduled debt payments, exposing creditors to loss.
What is Default Risk?
Default risk is the likelihood that a borrower — a corporation, sovereign government, or individual — will be unable or unwilling to meet its debt obligations as they come due. It is a subset of broader credit risk and is distinct from the amount of loss that would result from a default (loss given default). Lenders, bond investors, and banks assess default risk through quantitative models (credit scoring, financial ratio analysis, Altman Z-Score), credit ratings from agencies like Moody's and S&P, and market-implied signals like credit default swap spreads. Default risk is priced into the yield spread that borrowers pay above the risk-free rate: higher perceived default probability demands wider spreads. Diversification can reduce portfolio exposure to individual defaults but cannot eliminate default risk across an economic cycle.
Example
The CDS market provides real-time market-implied default probabilities for major corporate and sovereign borrowers. In early 2023, the 5-year CDS spread on First Republic Bank widened from about 50 basis points to over 500 bps as depositors withdrew funds following Silicon Valley Bank's collapse — the CDS market was pricing a greater-than-50% probability of default within five years. First Republic was subsequently seized by regulators and sold to JPMorgan in May 2023, validating the market's assessment.
Source: Moody's — Probability of Default