What is the risk of default?
The risk of default is the possibility that a business or an individual may not be able to make the required payments on its debt. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. A higher risk level results in a higher required return and, in turn, a higher interest rate.
Key points to remember
- The risk of default is the possibility that businesses or individuals may not be able to make the required debt payments.
- Near free or negative free cash flow indicates that the company may have difficulty generating the cash required to make the promised payments, which could indicate a higher risk of default.
- Default risk can be measured using standard measurement tools, including FICO scores for consumer credit and S&P and Moody’s credit ratings for corporate and government debt problems.
Understanding the risk of default
Default risk can be measured using standard measurement tools, including FICO scores for consumer credit and credit ratings for corporate and government debt problems. Credit ratings for debt issues are provided by nationally recognized statistical rating organizations (NRSRO), such as Standard & Poor’s (S&P), Moody’s and Fitch Ratings.
The risk of default may change due to larger economic changes or changes in the financial condition of a business. The economic recession can have an impact on the revenues and profits of many businesses, influencing their ability to make interest payments on the debt and, ultimately, to repay the debt itself. Businesses may face factors such as increased competition and lower pricing power, resulting in a similar financial impact. Entities must generate sufficient net income and cash flow to mitigate the risk of default.
In the event of default, investors may lose periodic interest payments and their investment in the bond. A default could result in a 100% loss on the investment.
To mitigate the impact of default risk, lenders often charge rates of return corresponding to the debtor’s risk of default level.
Lenders generally review the financial statements of a business and use multiple financial ratios to determine the likelihood of debt repayment.
A technical default can occur if a debt can be repaid, but certain loan conditions cannot be met.
Free cash flow is the cash flow generated after the business is reinvested and calculated by subtracting capital expenditure from operating cash flow. Free cash flow is used for things like debt and dividend payments. A free cash flow close to zero or negative indicates that the business may have difficulty generating the cash required to make the promised payments. This could indicate a higher risk of default.
The interest coverage ratio is calculated by dividing a company’s profit before interest and taxes (EBIT) by its periodic interest payments on the debt. A higher ratio suggests that there is enough income generated to cover interest payments. This could indicate a lower risk of default.
Types of default risk
Credit ratings established by rating agencies can be grouped into two categories: investment grade and non-investment grade (or undesirable). Good quality debt is considered to present a low risk of default and is generally more sought after by investors. Conversely, non-investment grade debt offers higher yields than safer bonds, but it also comes with a considerably higher probability of default.
Although the rating scales used by the rating agencies are slightly different, most debts are rated the same way. Any bond issue rated AAA, AA, A or BBB by S&P is considered investment grade. Anything rated BB and below is considered non-investment grade.