Default risk, also called default probability, is the probability that a borrower fails to make full and timely payments of principal and interest, according to the terms of the debt security involved. Together with loss severity, default risk is one of the two components of credit risk.
Assessing Default Risk
While it is often useful to consider the whole distribution of potential losses and their respective probabilities, it is generally convenient to calculate a simple indicator of risk that considers a single default probability and loss severity. The indicator is called expected loss and can be calculated as follows:
Expected Loss = Default Probability x Loss Severity
The assessment of default risk is a necessary step in the valuation of government and corporate bonds or credit derivatives, such as credit default swaps (CDS). Since high-quality bonds generally come with low default rates, the assessment of default risk for such instruments is generally more important than the estimate of the loss severity in case of default.
Therefore, default risk is key in determining the price and yield of financial instruments. A higher default risk generally corresponds with higher interest rates, and issuers of bonds that carry higher default risk will often find it difficult to access to capital markets (which may affect funding potential).
While the definition of default risk is quite straightforward, its measurement is not. The level of default risk mainly depends on the borrower’s capacity; that is, the ability of the borrower to make its debt payments on time. A borrower’s capacity is influenced by many factors, which are discussed below.
1. Debtor’s financial health
Other conditions being equal, companies with high levels of debt relative to their cash flows, cash reserves, or assets will generally be less creditworthy than those with debt-free or debt-light balance sheets, liquid assets, or high cash-flows relative to debt.
A debtor’s financial health is generally assessed through an in-depth look at the fundamentals, including the analysis of profitability, cash flows, coverage ratios, liquidity, and leverage.
2. Economic cycle and industry conditions
A company’s performance may be negatively affected by external economic conditions or by issues that its customers or suppliers are facing.
In times of macroeconomic downturn or industry-specific weakness, even relatively healthy companies can face a deterioration in their creditworthiness and an increase in default risk for their bonds.
Conversely, during an economic boom or a very good period for a specific industry, even companies with a relatively poor financial health and a weak competitive position may experience an improvement in creditworthiness and a decrease in default risk.
3. Currency risk
If a company owes debt in one currency but generates cash flows in another, it will be exposed to the effects of currency fluctuations.
High volatility in the currency markets, if not properly hedged, can exert a significant impact on a company’s financial stability and creditworthiness.
4. Political factors and rule of law
Geopolitical issues, such as war, regime changes, or a corrupted environment can make it more difficult for a debtholder to effectively and efficiently collect payments or enforce its rights as a creditor.
Other conditions held equal, bonds issued by companies in countries with a troubled or uncertain socio-political environment will carry higher default risk than bonds issued by companies in more stable and more predictable environments.
5. Other risks
Some risks may be more difficult, and sometimes impossible, to measure.
Examples include litigation risk, environmental risk, and exposure to natural disasters.
Credit Rating Agencies
Credit rating agencies, such as Fitch Ratings, Moody’s Investors Services, and Standard & Poor’s play a key role in the assessment of default risk. The rating agencies use similar, symbol-based ratings that summarize their assessment of a bond’s risk of default. The agencies apply the ratings to all types of bonds, including corporate bonds, government bonds, government-related bonds, municipal bonds, supranational bonds, asset-backed securities, and so on.
Most corporate and government bonds will generally receive ratings from at least two of the agencies. The ratings are divided into two major categories – investment grade and non-investment grade, also called “high-yield” or “junk” – and sub-categories that define the security’s default risk more specifically.
Bonds rated triple-A (i.e., “AAA” or “Aaa”) are perceived to be of the highest quality and carrying the lowest level of default risk. As we go down from triple-A ratings, the probability of default increases, although, only below “BB–” or “Baa3,” the security loses its investment-grade rating to become a non-investment grade security.
In addition to the symbol-based rating, the agencies usually provide an outlook on the ratings, which can be positive, stable or negative, or other indications on the likely direction of the ratings, such as “on review for downgrade.”
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: