Final answer:
The spread between the interest rate on bonds with default risk and default-free bonds compensates investors for the higher risk associated with default-risk bonds. If interest rates change, the price of the bond with default risk will change accordingly. If interest rates rise, the price of the bond with default risk will decrease.
Step-by-step explanation:
Bonds with default risk, also known as high-yield or junk bonds, offer higher interest rates compared to default-free bonds. This higher interest rate is known as the spread between the two types of bonds. The spread compensates investors for the higher risk associated with default-risk bonds.
For example, if the interest rate on default-free bonds is 4%, and the spread for high-yield bonds is 2%, then the interest rate on high-yield bonds would be 6% (4% + 2%).
Therefore, if the interest rates change, we would expect the price of the bond to change accordingly. If interest rates rise, the price of the bond with default risk would decrease because the higher risk and higher interest rate may make it less attractive to investors. Similarly, if interest rates decrease, the price of the bond would increase.