Default Risk
It is the probability that a company will default on its debt.
What is Default Risk?
The probability that a borrower fails to meet their debt obligations promptly – breaking their contract is known as default risk. This means the borrower doesn’t pay their principal or interest payment on time.
Default risk is also known as default probability and is a metric used by lenders to determine the riskiness in dealing with said customers. If a borrower’s default probability is high, they can expect to be charged higher interest rates than someone with a lower probability.
On a business level, if a firm has a free cash flow figure around or below zero, this could indicate that it has a high chance of defaulting on its debt. If this firm tried to take out credit, they wouldn’t get favorable terms in the deal due to their default probability.
This risk is generally captured under two expenses that individuals and corporations are forced to pay down and account for when taking out debt:
- Interest Expense: The borrower makes payments to the lender throughout the term length of the debt.
- Mandatory Amortization: The required amount paid down for the principal during the length of the debt.
When lenders charge a higher rate for borrowers with a higher default probability, they charge them a default risk premium. They charge this premium to ensure they don’t lose money on the transaction if they lend funds to the borrower who defaults.
In some cases, if a borrower’s default probability is too high, the lender will outright deny lending to them. They won’t even give them the option of unfavorable terms and paying a premium.
NOTE
The default risk premium can be calculated by taking the difference between the interest rate pricing on a certificate of indebtedness and the risk-free interest rate.
Understanding Default Risk
Every time the lenders take risks and provide funds they borrowed, they determine their expected Loss. So, naturally, they want to keep this figure as low as possible to minimize the chance of losing money due to a default.
The Expected Loss is calculated by multiplying the default probability by the loss severity, or the amount (in value) of losses that materialize when a loan defaults:
Expected Loss = Default Risk * Loss Severity
It’s important to analyze this risk when valuing government-backed securities and credit derivatives.
Credit instruments like government bonds from developed and stable economies have low default probabilities, some even zero. Hence, default probability is more important than the expected loss estimate in this case.
The default probability is a key tool for both investors and lenders. A higher probability may mean that a lender will charge higher interest to a borrower, but it could also mean that a bond investor doesn’t invest in the bond because of its riskiness.
This risk can be affected by macroeconomic factors or changes on a micro level within the company. For example, when the economy is experiencing a recession, the revenues and profits of a company will likely decrease from revenues before the recession.
NOTE
When investing in bonds, it’s important to consider the defaulting probabilities. If you are looking for a safe investment, you should invest in the US Treasury Bond, a risk-free investment. On the other hand, there are more risky bonds that will generate better returns.
This will likely influence the company’s ability to make its debt obligations, especially if the decline in revenues and profits is substantial.
Economic factors like an increase in competition in the market or a lower pricing influence will also affect a company when trying to make its debt obligations. Therefore, companies ensure they have strong cash flows to avoid any problems.
Default risks can also be something that concerns investors. For example, individuals who invest in bonds will likely monitor the default probability. This is because if the bonds were to default, you would lose your entire investment along with the accrued interest income.
Understanding Borrowing Capacity
Measuring this risk is a little more complex than understanding its actual concept. First, to measure default probability, we need to understand borrowing capacity. Borrowing capacity is the borrower’s ability to meet its debt obligations promptly.
Many different things can influence the borrower’s ability to make their payments on time, such as:
The Borrower’s Finances
If the borrower has substantial debt and doesn’t have the necessary cash flows to account for this debt, they will be in trouble. When having high levels of debt, you must be able to pay it off – which usually comes from strong cash flows.
If companies have limited to no debt, they are considered more creditworthy. This is especially true when the firm’s cash flows are strong compared to the outstanding debt level.
NOTE
An analyst will use different income statements and balance sheet ratios to determine a borrower's financial health to put the company’s debt in perspective.
Macroeconomic Influences
Different issues impacting the whole economy or the industry may have a trickle-down effect on the company’s ability to pay its debt.
For example, if the industry has supply chain issues, the firm may not sell as many products, leading to lower cash flows.
Even companies with strong financials can face debt payment problems and an increase in their bond’s default probability, given poor market conditions.
NOTE
Market influences can also be very beneficial to firms too. For example, strong periods of the economic cycle can help firms with weaker financials improve their creditworthiness, and their bonds will have lower default risk.
Currency Volatility
If firms deal with different currencies used for their debt and revenues, they may experience fluctuations in the conversion between the currencies.
The value of currencies changes all the time, and a severe rise or fall in one currency could lead the firm to have trouble paying its debt off if the debt is in another, more stable currency.
Governmental Policies And Geopolitical Tension
When different geopolitical events affect the entire world and each country’s economy, they can surely affect a singular firm’s ability to pay its debt.
NOTE
Events like war, natural disasters, or changes in the person in power in different countries can strain the world economy. These events will stress borrowers trying to make payments and lenders trying to collect their payments.
While bonds issued by developed countries’ governments are usually stable and safe investments, bonds issued by less developed nations or nations facing political instability will have bonds with higher default probability.
Credit and Bond Ratings
Credit agencies are firms that store information, such as credit history, that is helpful for investors to use when determining whether to invest in a bond. For example, credit agencies analyze different bonds and calculate the default probability associated with each one.
The popular credit agencies you may have heard of are Fitch Ratings, Standard & Poor’s, and Moody’s Investors Services.
The agencies provide investors with different ratings to determine whether a bond is a safe or risky investment. These ratings give investors the default probability based on the specific category the bond is listed in.
Most of the bonds you’ll see receive a rating from at least two credit agencies, including government bonds. In addition, each bond is given an initial rating: investment grade and non-investment grade.
Investment-grade bonds are considered safer investments, meaning they are less likely to default. Conversely, non-investment grade bonds, also known as junk bonds, are riskier investments with a higher chance of defaulting.
NOTE
Even though some bonds are called non-investment grade, you can still invest in them. These bonds are even likely to pay you more in interest payments. They’re called “non-investment grade” because of their high chance of defaulting, resulting in you losing your investment.
The bonds are then given a specific rating depending on the level of risk. For example, if the bond is of the highest quality and safest, it will receive a triple-A rating – the highest rating a bond can get.
For every incremental bond rating decrease, the bond’s defaulting probability will decrease. Bonds are considered investment grade or safe until they surpass a “BB-” rating.
After this rating, they will officially move into the non-investment grade category.
Agencies will often provide more context to their ratings. For example, they will describe whether the outlook for the bond is positive, neutral, or negative. They may also alert investors of other information they think is material when investing in the bond market.
Default Risk FAQs
Default risk is the probability that a company will default on its debt. Lenders keep this probability in mind when lending credit to individuals.
If a borrower’s default probability is too high, that borrower can expect to pay extremely high-interest rates or may not be able to receive the loan at all. On the other hand, if the borrower has a low default probability, they may receive relatively favorable debt terms.
Companies use credit agency ratings to measure default risk, especially for bonds. These credit agencies will rate the default probability of bonds and other financial instruments based on their default probability.
If these instruments are likely to default, they will be in the non-investment grade category, alerting people not to invest in them. On the other hand, if they’re considered relatively safe, they will be put in the investment grade category and then assigned a more specific rating based on relative risks.
Cash flow issues are a big reason companies default on their debt. In addition, macroeconomic factors, geopolitical events, and currency fluctuations can cause these issues. All these issues can severely lower a company’s cash flows, even if they’re usually a financially strong, stable company.
For individuals, it’s important to pay debt obligations on time and try not to miss any payments. Missing payments and declaring bankruptcy are two major actions that can severely impact your credit score, influencing your default probability poorly.
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