What is a Default Risk Premium?
A default risk premium is effectively the difference between a debt instrument’s interest rate and the risk-free rate. The default risk premium exists to compensate investors for an entity’s likelihood of defaulting on their debt.
What determines the default risk premium?
Default risk premiums essentially depend on a company or an individual’s creditworthiness. There are a variety of factors that determine creditworthiness such as:
If a person or company has regularly made interest payments on time on past obligations, it signals to issuers that the entity is trustworthy. If the entity has taken on incremental debt obligations (i.e., increasing amounts of debt every time debt was taken on) and managed to stay on top of interest payments, issuers will consider the entity more trustworthy as well.
Thus, issuers will allow this entity to borrow more money at a lower interest rate since the entity’s probability of default is relatively low. In such a case, the default risk premium charged will be low. The opposite is also true; a poor credit history will make issuers charge a higher default risk premium.
Liquidity and profitability
Issuers may also examine an entity’s financial position. For example, if a business was applying for a loan from a bank, the bank might examine some of the business’ recent financial statements. If the business seems to be generating reliable month-over-month revenue, effectively manage costs and see profits, banks may be more inclined to charge a lower default risk premium.
Examining the business’ balance sheet and cash flow statement will also provide some insight into the business’ liquidity (i.e., ability to meet monthly cash obligations, such as interest payments). The opposite is also true; poor liquidity and profitability will solicit a higher default risk premium.
Assets make borrowers attractive to banks, as the loans can be collateralized against them. For example, if a business owns a $5-million building and would like to take on a $5 million loan to finance its operations, a bank might use the building as collateral. In such a situation, the bank would be able to claim ownership of the building in the event that the business was no longer able to make interest payments.
Collateralization also underpins mortgage agreements, where banks can reclaim ownership of a property if the borrower is no longer able to make interest payments. Owning lots of collateralizable assets usually enables borrowers to secure larger debt, but may not directly affect the default risk premium. Here again, the opposite is true; an entity with few assets will not be able to secure as much debt.
What are the components of an interest rate?
From the perspective of a bond investor, the minimum required return he/she will expect is equal to the sum of the following:
- Default Risk Premium – compensates investors for the business’ likelihood of default
- Liquidity Premium – compensates investors for investing in less liquid securities such as bonds
- Maturity Premium – compensates investors for the risk that bonds that mature many years into the future inherently carry
- Projected Inflation – accounts for the devaluation of currency over time
- Risk-free Rate – refers to the rate of return an investor can expect on a riskless security (such as a T-bill)
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: