What is a Default Risk?

Default risk refers to the chance that individuals or companies would be unable to make the needed payments on their debt obligations. Investors and lenders are exposed to default risk in almost every form of credit extensions. [Important: To reduce the effect of default risk, lenders often charge return rates corresponding to the debtors default risk level.] A higher risk level results in a higher required return.

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How Does a Default Risk Work?

Default risk can be measured using standard measurement tools, including FICOscores for consumer credit, as well as, credit ratings for government and corporate debt issues. Nationally recognized statistical rating organizations (NRSROs) provide credit ratings for debt issues like Moodys, Fitch Ratings, and Standard & Poors (S&P). Default risk can change due to wider economic changes or changes in the financial situation of a company. Economic recession can affect the earnings and revenues of many companies, Affecting their ability to make interest payments on debt and, eventually, pay the debt. Companies might encounter factors like lowering price power, increased competition, and resulting in a similar financial effect. Entities need to generate enough cash flow and net income to reduce default risk. Supposing there is a default, investors might lose out on their investment in the bond, as well as, periodic interest payments. A default can bring about 100% investment loss.

Indications of Increased Default Risk

Lenders usually examine the financial statements of a company and also employ some financial ratios to ascertain the possibility of debt repayment. Free cash flow is the cash gotten after the company reinvests in itself and is calculated by deducting capital expenditures from operating cash flow. Free cash flow is utilized for things like dividends and debt payments. A free cash flow figure which is negative or near 0 shows that the company might be experiencing difficulty generating the cash needed to deliver on promised payments. This can show a higher default risk. The interest coverage ratio is derived by dividing the earnings before interest and taxes (EBIT) of a company by its periodic debt interest payments. A higher ratio posits that there is sufficient income generated to cater for interest payments. This can notify of lower default risk.

Investment Grade vs. Non-Investment Grade

The credit scores which the rating agencies established can be segmented into two groups: investment grade and non-investment grade/junk. Investment-grade debt is termed to have low default risk and investors are always more interested in it. On the other hand, non-investment grade debt offer more yields than safer bonds, but this comes alongside a significantly higher possibility of default; While the grading scales utilized by the ratings agencies are a bit different, most debt is graded alike. Any bond issue which S&P rates either an AAA, AA, A, or BBB is termed investment grade. Any bond issue with the rating BB or below is termed non-investment grade. 

Key Takeaways 

Default risk refers to the chance that individuals or companies would be unable to make the needed payments on their debt obligations. A free cash flow figure which is negative or near 0 shows that the company might be experiencing difficulty generating the cash needed to deliver on promised payments. This can show a higher default risk. Default risk can be measured using standard measurement tools, including FICO scores for consumer credit, as well as, credit ratings for government and corporate debt issues.