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What Is Default Risk
In business, default risk refers to the chance that a contracting party, individual, or company defaults on its financial obligations.
In other words, a party that is potentially unable to pay its debt obligations when they become due poses a default risk to its lender.
Typically, lenders, investors, and those extending credit to others are exposed to default risk as they run the chance that the borrower cannot make the required payments on time.
The more an investor is exposed to default risk, the more the investor will demand a higher rate of interest to compensate for the additional risk.
The less an investor is exposed to default risk, the lower interest rates will be warranted.
Why Calculate Default Risk
Lenders and investors consider a borrower’s default risk to assess whether or not they can tolerate the level of risk and set the appropriate rate of interest.
The idea is to measure the probability that a company or individual does not pay its debt obligations on time.
Calculating default risk is essential for evaluating investment risk and making decisions within a determined risk management strategy.
The default risk can change depending on broad economic factors.
For example, in a period of recession, default risk will be higher than in expansionary periods.
The default risk can also change depending on the company or individual in question.
For example, if a company loses a few major contracts or suffers a sudden increase in fixed costs, its default risk may change.
Lenders and investors can assess a company’s balance sheet and financial statements to measure the company’s default risk or look at nationally recognized statistical rating organizations such as Moody’s, Fitch Ratings, and Standard & Poor’s.
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How To Measure Default Risk
There are different ways of measuring a person or entity’s default risk.
The first method is to assess default risk by looking up a person or company’s credit reports.
There are credit reporting agencies that collect financial information on individuals and come up with a rating.
The higher the person’s credit rating, they are prone to less default risk.
The lower the person’s credit rating, the more they are prone to default risk.
For companies, you can measure a company’s default risk by consulting nationally recognized statistical rating organizations like Moody’s, Fitch Ratings, and Standard & Poor’s.
These agencies will rate companies based on their potential default risk.
Also, lenders and investors can also demand that the company share financial information to see how much cash flow and profits they generate.
A company with high fixed costs and low cash flows will have a much higher default risk than a company with low fixed obligations and high cash flow.
Default risk can be influenced by many factors such as the borrower’s financial health, economic factors, industry factors, currency risk, political factors, legal factors, environmental factors, and so on.
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Default Risk Indicators
There are different indicators that can suggest that a company is exposed to a higher potential to default on its debt obligations.
The first indicator that investors and lenders consider assessing a company’s default risk is the company’s free cash flow.
Free cash flow is the amount of cash the company generates that the company can use to pay off debt or distribute dividends to its shareholders.
The lower a company’s free cash flow, the more there is potential for default risk.
Another measure that is useful to consider is the company’s ability to service its debt.
The more the company generates cash flow to service its debt, the better the company’s financial position.
You can also look at the company’s interest coverage ratio to see if the company generates enough cash to cover its interest obligations.
Another way you can see that a company may have liquidity issues is the reduction of its working capital without any corresponding capital investments.
This means that the company may be depleting its net working capital to pay for business expenses thereby distracting money away from important capital investments.
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Default Risk Ratings
There are different rating agencies that rate corporations and businesses to help the market assess their default risk.
For instance, companies and governments issuing bonds are rated for their default risk.
Government bonds have a lower default risk than corporate bonds as it’s not as likely that a government defaults on its debt compared to a corporation.
Rating agencies will rate investment instruments in two broad categories: investment grade and non-investment grade (or junk).
When a company’s financial securities are considered investment grade, it means that the company exposes the investor to lower default risk.
On the other hand, when the financial instrument is a non-investment grade, the investor will be exposed to a much higher level of default risk.
Investment grade is typically rated as BBB, A, AA, or AAA by Standard and Poor’s.
Anything at the BB level or lower is considered non-investment grade.
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Default Risk FAQ
What is an example of default risk?
An example of default is when a company does not respect its obligations on bonds or debentures.
When a company issues corporate bonds, it is essentially borrowing money from the public.
On a standard bond, the company will need to make regular interest payments on the principal and eventually pay the face value of the bond back to the investor.
If the company defaults on its interest payments or is unable to make a principal payment on time, the company will be in default.
Default risk measures the likelihood that a company defaults on its debt obligations.
How do you assess default risk?
There are different ways you can assess default risk.
One way is to consult a company’s financial statements and calculate different financial ratios allowing you to measure the default risk.
Another way is to consult reports provided by credit rating agencies.
You can also look at the company’s reputation, recent news on the company, economic indicators, and so on.
How do you manage default risk?
The primary way that an investor or lender will manage risk is by setting a rate of interest that compensates it for the level of risk taken.
The rate of interest increases as the default risk increases.
Also, lenders will ask that borrowers put up assets as collateral to the loan if they pose a higher level of risk.
In addition, borrowers will sign restrictive covenants where they are required to use the capital to fund their business, provide lenders with their financial statements on a regular basis, and take other measures to reduce their overall risk profile.
Takeaways
So there you have it folks!
What does default risk mean?
In a nutshell, default risk refers to the risk that a person or company defaults on its debt obligations.
Lenders and investors are exposed to default risk whenever they extend credit to their clients or lend money.
When investors are exposed to a higher level of default risk, they will demand a higher rate of interest.
If the default risk is low, then the rate of interest should be correspondingly lower as well.
Now that you know what default risk is all about and how it works, good luck with your research!
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