Default Risk Premium Definition
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.
Table of contents
- 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 riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors., 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.
Default Risk Premium Formula
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 RateRisk-Free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk. and the Interest Rate charged by the lender. The interest rate comprises the following components – Inflation premium, maturity premium, liquidity premiumLiquidity PremiumLiquidity premium refers to the extra compensation desired by the investors for holding assets that are either difficult to be converted into cash or tradable in the open market at a fair price., 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
How to Calculate Default Risk Premium?
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 rateCoupon Rate The coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100% 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 deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy., 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 bondCorporate BondCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value. will be 10% – 1%, that is 9%.
- Step 3 – Now, the estimated rate of inflationRate Of InflationThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100. 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%).
- 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%
Factors that Determine Default Risk Premium
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 profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. 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.
Frequently Asked Questions (FAQs)
The interest rate that must be provided to attract investors will increase directly to the default risk of a hazardous bond. Investment choices from an investor’s standpoint, the default risk premium influences investment choices by contrasting the default premium of similar bonds.
A risk premium, in general, is a means to reward an investor for taking on more risk. Risk premiums may be reduced for investments with lesser risk. An extremely low-risk investment’s return occasionally could have a negative risk premium.
For investors, a higher default risk premium means earning higher returns for taking on greater risk. On the other hand, borrowers face higher borrowing costs if they are perceived as having a higher risk of default. This translates into higher interest rates on loans and bonds, making it more expensive for them to raise funds in the financial markets.
Higher credit ratings have lower default premiums and lower yields and are assigned to businesses that generate more money or are more secure.
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 –