If the interest rate for a loan is high then the risk for default also gets higher. So can anyone please explain the idea behind this concept of adjusting the interest rate for a higher default risk?
You are right that if you raise the interest rate on a borrower, the risk that they cant make the payments and therefore default, also gets higher. But that is just the way of the world. The creditor is most worried about the repayment of the 100 principle than the payment of interest, and this will be the same no matter what the coupon rate on the bond is. So the fact is that if you are a good credit, lots of people want to lend to you. So you can take advantage of this and issue a bond with a 2% coupon on it and people will still invest in it. If you are a bad credit, very few people want to invest in your issue, so you have to raise the interest rate to attract them. Therefore you end up issuing with a 8% or so coupon rate. Hope this helps.
