What is Default Risk
Default risk is the chance that companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk. A higher level of risk leads to a higher required return.
BREAKING DOWN 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.
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.
In the event of a default, investors may lose out on periodic interest payments and their investment in the bond. A default could result in a 100% loss on investment.
Indications of Increased 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 0 or negative indicates that the company may be having trouble generating the cash necessary to deliver on promised payments. This could indicate higher 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 lower default risk.
Investment Grade vs. Non-Investment Grade
The credit scores established by the ratings agencies can be grouped into two categories: investment grade and non-investment grade, or junk. Investment-grade debt is consider 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 ratings 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.