Default Risk

Last Updated :

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Blog Author :

WallStreetMojo Team

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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What is Default Risk?

Default risk is the type of risk that measures the chances of not fulfilling the obligations such as non-repayment of principal or interest and is mathematically calculated based on the past commitments, financial conditions, market conditions, liquidity position and present obligations, etc. Many factors affect default like heavy losses suffered, blockage of money in long term assets, poor cash flow and financial position, economic conditions like recession, etc. It is measured by the ratings issued by the credit rating agencies.

Table of contents

Types of Default Risk Rating

The lower the ratings, the higher the risk, and vice versa. If the default risk is high, the interest will be more than the middle part to attract the customers to invest. It is bifurcated into two types of investment-grade and non-investment grade.

Types-of-default-Risk

#1 - Investment Grade

Investment Grade is the type of rating given by credit rating agencies based on the performance of the company, which determines the lower default risk, and investors can opt for investment in the company. Generally, the Ratings of AAA, AA, A, BBB are considered in the category of investment grade.

#2 - Non-Investment Grade

Non-Investment grade rating is considered high-risk securities, and it shows that the chances of default are more. Non-investment grade companies offer a higher rate of interest and lower purchasing prices due to their nature of risk. Sometimes non – investment-grade companies found it difficult to attract the customers to purchase the securities. The grade below BB by credit rating agencies indicates the non – investment grade.

Default Risk

How to Reduce Default Risk?

#1 - Offer High Rate of Interest

The borrower should offer a higher rate of interest as compared to the market rate to keep the faith of the investors.

#2 - Proper management of Cash Flow position

If the company is rated in non – investment grade, then it should maintain the proper cash flow to timely repay the debt and better the market image.

#3 - Favorable Capital Structure

The owned capital should be more than the borrowed money to maintain the solvency position.

#4 - Favorable Ratios

Credit Rating agencies rate the securities by financial position and ratio analysis of the borrower company. To reduce the default risk, the ratios like debt-equity ratio, profitability ratio, stock turnover ratio, solvency ratios, working capital ratio, etc. should be favorable to the business organization.

#5 - Other Measures

  • Reduce the cost
  • Maintain the profit percentage
  • Repay Bank loans on time
  • Low investment in long term capital assets

Assessing Default Risk

It can be evaluated using the following ways:

Assessing Default Risk

#1 - Credit Ratings

One can access this risk by the ratings given by the credit rating agencies. If the ratings are equal to or below BB, then the risk is high.

#2 - Past Performance and Quarterly Results

It can be assessed by the past performance of the company like if a company has defaulted in repayment of debt in the past, the default risk is to be accessed as high, or If there are poor quarterly results published, the chances of loss and risk are high.

#3 - Market Position and Goodwill

If the company or borrower has a higher reputation in the market, that means the company or borrower has excellent goodwill. So, one can trust the borrower and invest or lend the money based on reputation in the market on the faith that the borrower will overcome the unfavorable situation.

#4 - Type of Borrower

It can be assessed from borrower to borrower also. If the borrower is a Government company, the chances of loss become low; hence the risk will be below. Whereas if the borrower is the newly formed private company, the chances of risk are more; therefore, the default risk is to be assessed as high.

Default Risk Premium

Default Risk Premium is the premium for taking the risk of investing in the risk-based securities. It is the difference between the rate offered by high-risk securities and the risk-free rate. This premium is a way of attracting customers by providing high-interest rates or discounted purchase prices. It is the compensating measure against the risk of bearer securities.

Conclusion

  • Default risk is the risk of defaulting by the borrower. It shows the inability of the borrower to repay the funds borrowed. It is measured by the ratings given by credit rating agencies.
  • There are two types of default risk investing funds and non-investing funds. In investing fund rating is AAA, AA, or BBB, which shows the low risk and sign that money can be supported, whereas, in non-investing trouble, the ratings given are below or equal to BB, which is the sign of high-risk securities.
  • The borrower provides a higher rate of interest to reduce the risk.
  • The difference between the high risk-based securities and the risk-free rate is called the market risk premium, which is compensating for the risk bearers.