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
Lower the ratings higher the risk and vice versa. If the default risk is high the interest will be more than the normal interest 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 on the basis of 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 considered as 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 so as 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 so as to timely repay the debt and better the market image.
#3 – Favorable Capital Structure
The owned capital should be more than the borrowed capital so as to maintain the solvency position.
#4 – Favorable Ratios
Credit Rating agencies rate the securities by financial position and ratio analysis of the borrower company. so, in order 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 assessed 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 is 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 great goodwill. So, one can trust the borrower and invest or lend the money on the basis of reputation in the market on the faith that 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 the low hence the risk will below. Whereas if the borrower is the newly formed private company the chances of risk are more hence the default risk is to be assessed as high.
Default Risk Premium
It 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 the way of attracting customers by offering high-interest rates or discounted purchase price. it is the compensating measure against the risk 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 invested whereas in non-investing risk 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 in order 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 in nature 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 –