Final answer:
The taxability risk premium compensates bondholders for the possibility of default by the borrower, accounting for the increased risk associated with the borrower's potential inability to fulfill their payment obligations.
Step-by-step explanation:
The taxability risk premium is a component of the interest rate on a bond that compensates bondholders for the risk of default by the borrower. When an investor buys a bond, they expect a rate of return, which includes compensation for delaying consumption, adjusting for inflation, and a risk premium that considers the borrower’s riskiness. Therefore, the taxability risk premium directly addresses the concern that the borrower might default on their obligations, providing added compensation to the investor for accepting this increased risk.
Bonds that entail higher risks, such as those known as high-yield or junk bonds, typically offer higher rates of return to make up for the possibility of default. Bonds are also subject to market risks, where changes in prevailing interest rates can make existing bonds with lower interest rates less attractive relative to new issues, potentially causing losses to current bondholders who are locked into lower rates.