Default Risk: Definition, Types, and Ways to Measure

What Is Default Risk?

Default risk is the risk that a lender takes on in the chance that a borrower will be unable to make the required payments on their debt obligation. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. A higher level of default risk leads to a higher required return, and in turn, a higher interest rate. 

Understanding Default Risk

Whenever a lender extends credit to a borrower, there is a chance that the loan amount will not be paid back. The measurement that looks at this probability is the default risk. Default risk does not only apply to individuals who borrow money, but also to companies that issue bonds and due to financial constraints, are not able to make interest payments on those bonds. Whenever a lender extends credit, calculating the default risk of a borrower is crucial as part of its risk management strategy. Whenever an investor is evaluating an investment, determining the financial health of a company is crucial in gauging investment risk.

Default risk can change as a result of broader economic changes or changes in a company's financial situation. Economic recession can impact the revenues and earnings of many companies, influencing their ability to make interest payments on debt and, ultimately, repay the debt itself. Companies may face factors such as increased competition and lower pricing power, resulting in a similar financial impact. Entities need to generate sufficient net income and cash flow to mitigate default risk.

Default risk can be gauged using standard measurement tools, including FICO scores for consumer credit, and credit ratings for corporate and government debt issues. Credit ratings for debt issues are provided by nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's (S&P), Moody's, and Fitch Ratings.

Determining Default Risk

Lenders generally examine a company's financial statements and employ several financial ratios to determine the likelihood of debt repayment. Free cash flow is the cash that is generated after the company reinvests in itself and is calculated by subtracting capital expenditures from operating cash flow. Free cash flow is used for things such as debt and dividend payments. A free cash flow figure that is near zero or negative indicates that the company may be having trouble generating the cash necessary to deliver on promised payments. This could indicate a higher default risk.

The interest coverage ratio is one ratio that can help determine the default risk. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its periodic debt interest payments. A higher ratio suggests that there is enough income generated to cover interest payments. This could indicate a lower default risk.

The aforementioned measure reflects a high degree of conservatism, reflective of non-cash expenses, such as depreciation and amortization. To assess coverage based purely on cash transactions, the interest coverage ratio can be calculated by dividing earnings before interest, taxes, depreciation, and amortization (EBITDA) by periodic debt interest payments.

Types of Default Risk

Rating agencies rate corporations and investments to help gauge default risk. The credit scores established by the rating agencies can be grouped into two categories: investment grade and non-investment grade (or junk). Investment-grade debt is considered to have low default risk 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 significantly higher chance of default.

While the grading scales used by the rating agencies are slightly different, most debt is graded similarly. Any bond issue given a AAA, AA, A, or BBB rating by S&P is considered investment grade. Anything rated BB and below is considered non-investment grade.