In evaluating a bond, which factor describes the chance the issuer will fail to repay the principal and interest?

• A. Liquidity Risk
• B. Default Risk
• C. Inflation Risk
• D. Market Risk

Answer: (B)

Default risk is the probability that the bond issuer will fail to make the required principal and interest payments. When evaluating a bond, investors assess the issuer’s creditworthiness—the likelihood they will meet all contractual obligations. If default risk is high, there’s a real chance of losing part or all of the investment, so the bond must offer a higher yield to compensate for that risk. Credit ratings from agencies provide a quick gauge of default risk, with lower ratings signaling higher risk and typically higher yields. Factors that drive default risk include the issuer’s earnings stability, debt load, cash-flow coverage, and overall financial strength, as well as broader economic conditions. In the event of bankruptcy, recovery of value can vary, so the risk isn’t just about missed payments but also about how much can be recovered. By contrast, liquidity risk is about how easily the bond can be sold, inflation risk concerns purchasing power over time, and market risk relates to price moves from changes in interest rates and market conditions.