Default risk is a probability that a borrower fails to make complete and scheduled payments under the terms of a debt obligation. The term is sometimes replaced by default probability or credit risk. Almost all types of credit extensions subject creditors and investors to default risk. A higher amount of default risk results in a larger expected return, and hence a higher interest rate. It is determined by the evaluations of credit rating agencies.
When a borrower has a high default risk, it must pay a considerably higher interest rate and may have difficulty getting funding at all. When the default risk on a current bond rises, the market value of the bond will probably drop as investors sell their stakes. This inversely affects the coupon on the bond. Since when the value of the bond drops, the coupon increases as a percentage of the cost of the bond.
Impact of default risk
At this point, we have understood that this risk is usually priced into securities. It is also important to be familiar with how to measure default risk. It is usually measured by the default risk premium, which is the difference between the interest paid by the debtor's bond, and the risk-free rate. The higher the difference between the risk-free rate, and the interest on the bond the higher is the default risk.
Factors of default risk
There are many reasons that influence default risk, including significant losses, money being blocked in long-term assets, inadequate cash flow. Factors such as financial condition, economic situations such as bankruptcy, are also taken into account. These factors are categorized as follows:
Business risk evaluates several elements impacting the debtor's external and internal business environment. These factors are classified as follows:
- Changes in the economic circumstances, administrative or legislative risks, political or governmental risks, and risks connected with the operation of financial systems are all characteristics of country-specific risks.
- Possible changes in industrial growth patterns and market structure, as well as economic cycles of the industry, are examples of industry-specific risks.
- Changes in competitiveness, operating productivity, and profitability also affect business risk and possibly increase the default risk. Factors such as loss of market share, managerial quality, governance practices concerns including trust, responsibility, and transparency are also determinants. These are all examples of company-specific risks.
The quantitative and qualitative evaluation of a borrower's capacity to manage and repay debts is known as financial risk. The cash flows, liquidity, profits, and asset quality of a firm may be used to quantify financial risk.
Types of default risk evaluation
The higher the risk, the lower the ratings, and vice versa. If the risk is higher, the interest rate will be greater than in the middle to encourage consumers to invest. It is divided into two categories: investment grade and non-investment-grade.
Investment Grade is a credit grade issued by credit rating institutions based on the business's performance. It indicates the low credit risk and gives investors confidence to either invest in the company’s equity and bonds. Ratings vary depending on the agency. However, most agencies will use a combination of letters to determine the risk of default. The higher quality debt instruments will be rated AAA, AA, A, and BBB. These are generally regarded to be investment grade, which means the risk of default is very low. Some credit agencies also use plus and minus signs in order to show the likelihood of default.
Non-investment grade assessment is considered as high-risk securities, indicating a higher likelihood of default. Although they are subdivided according to their inherent risks, some of the non-investment-grade bonds are deemed junk bonds or high-yield bonds. The high yield is related to the higher interest on the coupon, reflecting the higher degree of risk. Due to the nature of their risk, non-investment grade firms provide a higher rate of interest and lower purchase prices. It might be difficult for non-investment-grade firms to persuade clients to acquire their assets. Credit rating firms assign a grade below BB to non-investment grade debt.
Credit rating agencies
Organizations such as Moody's, Fitch, and Standard & Poor's play an important role in determining default risk. Their goal is to rate the credit of different companies and countries according to their credit risk. The rating agencies employ comparable, symbol-based ratings to describe their opinion of a bond's default risk. Corporate bonds, government bonds, government-related bonds, municipal bonds, supranational bonds, asset-backed securities, and other forms of debt instruments are all rated by the agencies.
Example of default risk
Consider sovereign risk, which is connected with the government's inability to repay its debts. Because the debt is guaranteed by the government, sovereign default is the least likely scenario. However, Greece is alleged to have defaulted on loan repayment to the International Monetary Fund (IMF) in 2015. Skipping a repayment of €1.6 billion.
The primary cause claimed for Greece's demise was structural issues that resulted in widespread tax avoidance. As their underground economy grew larger and larger, the government’s ability to collect taxes was extremely reduced. That coupled with several years of increased debt, pushed the country at the brink of collapse.
Another case of sovereign default occurred in 2002 when Argentina failed to repay an $ 805 million installment to the World Bank. It only commenced paying once the International Monetary Fund (IMF) reinstated its loan line.
More recently Evergrande and some other Chinese companies in the construction sector have been defaulting on their debt. Years of heavy speculation across the Chinese housing market have created this situation. When this finally unfolds, some sectors that are dependent directly and indirectly on construction will also suffer tremendous consequences. As the Chinese real estate market downfall will continue to unfold.
As we have seen, default risk is the lowest risk that exists for all sorts of debt instruments. However, it is something that investors should always consider. Although it is not common for a company, let alone a country to default, it may happen. When you are investing you should consider all of the possible outcomes and scenarios.
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