What does default risk refer to in investment contexts?

Default risk specifically refers to the potential that a borrower, which can include corporations or governments, will fail to fulfill their obligations to make interest or principal payments on their debt. This risk is critical in the context of investments because when borrowers default, investors may suffer financial losses. Understanding default risk is essential for investors to evaluate the creditworthiness of issuers in their investment portfolios.

In fixed-income securities, such as bonds, default risk is particularly significant because it directly affects the yield on those securities and can also influence the overall risk profile of an investment portfolio. Higher default risk usually results in higher yields to compensate investors, while lower default risk typically corresponds with lower yields, reflecting the safety perceived by investors.

This understanding allows investors to make more informed decisions regarding the potential risks and returns associated with various investments and to strategically allocate their resources to mitigate such risks effectively.