Default Probability: Definition for Individuals & Companies

What Is Default Probability?

Default probability is the likelihood that over a specified period, usually one year, a borrower will not be able to make their scheduled repayments on a particular debt. It can be applied to a variety of different risk management or credit analysis scenarios. Also called the probability of default (PD), it can depend not only on the borrower's characteristics, but also on the general economic environment.

How Default Probability Works

Creditors typically expect to receive a higher interest rate to compensate them for bearing higher default risk. Financial metrics—such as cash flows relative to debt, revenues or operating margin trends, and the use of leverage—are common considerations when evaluating the risk of lending to a particular company. The company's ability to execute a business plan is sometimes factored into the analysis, as well.

For businesses, a probability of default is implied by their credit rating from independent rating agencies, such as S&P Global Ratings, Fitch Ratings, or Moody's Investors Service. PDs may also be estimated using historical data and statistical techniques. PD is used along with "loss given default" (LGD) and "exposure at default" (EAD) in a variety of risk management models to estimate possible losses faced by lenders. Generally, the greater the default probability, the higher the interest rate the lender will charge the borrower.

Individuals can encounter the concept of default probability when they go to borrow money to purchase a residence. When a would-be home buyer applies for a mortgage, the lender makes an assessment of the buyer's default risk, based on their credit history and financial resources. The higher the estimated probability of default, the greater the interest rate that the borrower may have to pay (if the lender is willing to issue a loan at all). For consumers, a credit score, such as a FICO score, implies a particular probability of default.

High-Yield vs. Low-Yield Debt

The same logic comes into play when investors buy and sell fixed-income securities, like corporate bonds, on the open market. Companies that are cash-flush and have a low default probability will be able to issue debt at lower interest rates. Investors trading these bonds on the open market will price them at a premium compared to riskier debt. In other words, safer bonds will have a lower yield.

If a company's financial health worsens over time, investors in the bond market will adjust to the increased risk and trade the bonds at lower prices and therefore higher yields (because bond prices move in an opposite direction to yields). High-yield bonds have the highest probability of default and therefore pay a high yield or interest rate. At the other end of the spectrum are government bonds like U.S. Treasury securities, which typically pay the lowest yields and have the lowest risk of default; governments can always raise taxes or print more money to pay back their debt.

The Bottom Line

Default probability attempts to measure the likelihood that a particular borrower won't be able to fully repay a particular debt. It is used in both business and consumer lending and can have a major influence over the interest rate that a borrower will have to pay. The same concept applies when companies or governments look to borrow money by issuing bonds or similar securities.