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.
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.
#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 gradeInvestment GradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments..
#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.
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 positionSolvency PositionSolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease..
#4 – Favorable Ratios
Credit Rating agencies rate the securities by financial position and ratio analysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements. of the borrower company. To reduce the default risk, the ratios like debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. , profitability ratioProfitability RatioProfitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms., stock turnover ratio, solvency ratiosSolvency RatiosSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business., working capital ratio, etc. should be favorable to the business organization.
#5 – Other Measures
- Reduce the cost
- Maintain the profit percentageProfit PercentageThe profit percentage formula calculates the financial benefits left with the entity after it has paid all the expenses. Profit percentage is of two types - markup expressed as a percentage of cost price or profit margin calculated using the selling price.
- Repay Bank loans on time.
- Low investment in long term capital assets
Assessing Default Risk
It can be evaluated using the following ways:
#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 below. Whereas if the borrower is the newly formed private companyPrivate CompanyA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. , 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 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.. This premium is the way of attracting customers by providing high-interest rates or discounted purchase prices. It is the compensating measure against the risk of bearer securities.
- 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 premiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities., which is compensating for the risk bearers.
This has been a guide to what is default risk and its definition. Here we discuss types, accessing, and how to reduce default is along with its premium. You may learn more about financing from the following articles –