Default Risk Premium

The default risk premium is an additional amount of interest rates paid by a borrower to lender/ investor as compensation for the higher credit risk of the borrower assuming his failure to pay back the principal amount in the future and can be mathematically described as the difference in between the interest rates payable on bond and a risk-free rate of return.

• The default risk premium is an additional interest rate a borrower pays to lenders/investors for higher credit risk, calculated as the difference between bond interest rates and risk-free rates.
• It is a compensatory payment for investors or lenders in default on debt, typically applicable to bonds. Lenders charge higher premiums if the borrower defaults on recurring interest payments or principal amounts, incentivizing them to take more risk.
• Lenders charge higher default risk premiums for poor credit, while the government pays dividends in favorable conditions to attract investors and offer higher yields.

Default risk premium (DRP) works as compensatory payment to investors or lenders if, in any case, the borrower defaults on their debt. DRP is commonly applicable in the case of bonds. Any lender will charge a higher premium if there are chances that the borrower will default in meeting out its debt servicing, i.e., defaults in either recurring interest payments or principal amount as per the agreed terms and conditions. It acts as an incentive for the lender to get rewarded more for the risk undertaken.

If the lender assumes that the borrower can default in complying with its debt servicing terms and conditions, i.e., risk of non-payment, the lender may charge a higher DRP. Investors with poor credit records pay a greater interest rate to borrow money. If adequate DRP is not available, an investor will not invest in companies more prone to default. If a company depicts lower default risk, this, in turn, will lower the future cost of raising capital for the company as such companies will get funds at lower DRP. The government does not pay a default premium except in unfavorable conditions to attract investors and pay higher yields.

DSR formula is represented as below -

DRP = Interest Rate Charged by Lender - Risk-Free Rate of Interest

DRP = Total Interest Charged - Other Component Of Interest

DRP is the difference between the Risk-Free Rate and the Interest Rate charged by the lender. The interest rate comprises the following components – Inflation premium, maturity premium, liquidity premium, risk-free rate, and DRP. The risk-free rate is based on an asset that possesses no risk. DRP generally deals with treasury bonds, as the US government backs these bonds. The default risk premium is the amount above the rate of treasury bonds that any investor would like to earn on an investment

DRP is the estimated return on a bond reduced by a risk-free return rate on investment. To calculate the DRP of a bond, the bond's coupon rate needs to be reduced by a risk-free return rate. It can be understood through the following steps.

• Step 1 - The rate of return for risk-free investment should be determined. The principal amount will grow with inflation while reducing deflation, and the US government backs the security. Say the rate of risk-free security is 1%.
• Step 2 - If a corporate bond that we wish to purchase offers 10% of the annual rate of return, then subtracting treasury’s rate of return from a corporate bond will be 10% – 1%, that is 9%.
• Step 3 - Now, the estimated rate of inflation will be subtracted from the above difference. If inflation is estimated to be 4%, the value will be 9% – 4%, 5%.
• Step 4 - If any other premium is included in the bond-like liquidity premiums, subtract those premiums. For example, if the bond carries a liquidity premium of 1%, subtracting 1% from 4% will arrive at 3% of the default risk premium.

ZYDUS Ltd. is issuing bonds with a 10% annual percentage yield. Now, suppose the risk-free rate is 1%. In that case, inflation of that particular year is estimated to be around 3%, and the liquidity and maturity premiums of the bonds are both 1%, adding all of these together with the sum totals to 6%. Hence, this bond’s default risk premium equals 4% of the annual percentage yield (10%) – other interest components (6%).

Solution

Here,

• The total Interest charged is 10%
• Other components of interest = (risk-free rate + inflation rate + liquidity premium + maturity premium)

• = 10% - (1%+3% + 1% + 1% )
• = 10% - 6%
• DRP =  4%

The following are the factors that determine DRP -

• Credit History - Any entity is considered trustworthy if it has paid previous debts on time with interest payments. Such companies or individuals are presumed to have lower default risk, and therefore they get access to cheaper funds as lenders charge lower DRP from them.
• Credit Worthiness - Companies with poor credit ratings and lower-grade bonds pay more default risk premiums. The companies are rated based on their financial performance by rating agencies such as Moody’s, Fitch, and S&P. Better the financial performance is the credit rating. Higher credit rating results in a lower default risk premium, and hence the investor would not get high returns since the risk is less.
• Liquidity and Profitability - The company’s profitability helps banks know their creditworthiness before giving loans. The cash flows are examined to determine if the company has enough cash to meet its interest obligations.

• With a high default risk premium, the market compensates investors more for undertaking greater risk by investing in such companies.
• Novel and risky business investments offer above-average returns, which the borrower can use as an earning reward for investors on investment risk.
• The riskier a particular asset is, the greater is the required return from that asset.
• DRP helps assign a relative risk rating to a particular asset for the investor.
• DRP helps determine the level of risk an investor or lender has to undergo if a borrower defaults on the loan.

This has been a guide to Default Risk Premium and its definition. Here we discuss formula, purpose, and how to calculate default risk premium along with an example and advantages. You may learn more about financing from the following articles –

• Risk Premium Formula
• Market Risk Premium
• Default Risk
• Debt Default