Default probability is the likelihood over a specified period, usually one year, that a borrower will not be able to make scheduled repayments. Default probability, or probability of default (PD), depends not only on the borrower's characteristics but also on the economic environment. For consumers, a FICO score implies a particular probability of default. For businesses, a probability is implied by their credit rating. PDs may also be estimated using historical data and statistical techniques. PD is used along with "loss given default" (LDG) and "exposure at default" (EAD) in a variety of risk management models to estimate possible losses faced by lenders. Generally, the higher the default probability, the higher the interest rate the lender will charge the borrower. Creditors typically want a higher interest rate to compensate for bearing higher default risk.
Breaking Down Default Probability
People sometimes encounter the concept of default probability when they purchase a residence. When a home buyer applies for a mortgage on a piece of real estate, the lender makes an assessment of the buyer's default risk, based on his/her credit score and his/her financial resources. The higher this estimated probability, the greater the interest rate that will be offered to the borrower.
The same logic comes into play when investors buy and sell fixed-income securities 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, the 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 at higher yields.
In the bond market, 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, which typically pay the lowest yields.