What Is Default Risk?

Default risk is the chance that a company or individual 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 risk leads to a higher required return, and in turn, a higher interest rate. 

Key Takeaways

• Default risk is the chance that companies or individuals won’t be able to make required debt 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, and this could indicate higher default risk.
• Default risk can be gauged using standard measurement tools, including FICO scores for consumer credit, and credit ratings by the likes of S&P and Moody’s for corporate and government debt issues.

Understanding 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.

To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk.

Special Considerations

Lenders generally examine a company's financial statements and employ several financial ratios to determine the likelihood of debt repayment.

A technical default can occur if a debt can be repaid, but certain conditions of the loan cannot be met.

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 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.

Types of 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.