What is Default Risk?

Default risk is the possibility that the issuer of a bond will not be able to repay the underlying principal or make scheduled interest payments. Entities at highest risk of default typically have a risky capital structure and unreliable cash flows that become more uncertain when economic conditions worsen. When an issuer has a high default risk, it must pay a significantly higher interest rate, and may have trouble obtaining financing at all. When the default risk on an existing bond increases, the market price of the bond will likely decline as investors sell off their holdings.

Default risk also applies to the credit granted by a supplier to its customers. A default here will increase the supplier’s bad debt expense. Some companies are willing to take on a higher level of default risk in order to increase their sales to customers with lower credit quality. This can be a viable strategy, as long as these companies balance the increased risk level against the profits to be gained by engaging in these sales.

How to Measure Default Risk

Default risk is measured with the ratings issued by credit rating agencies. They have a proprietary measurement system that uses a number of factors to arrive at a score for each targeted party. Many larger businesses develop their own default risk scores, rather than using a rating agency’s score. These internally-generated scores are based on historical payment data for each customer, combined with other factors that may be weighted differently to arrive at scores that yield the best results for these businesses.

Assessing Default Risk

An easy assessment tool for default risk is the concept of expected loss. It is calculated as the probability of default, multiplied by the loss severity. The formula is:

Probability of default x Loss severity = Expected loss

For example, a high-quality bond has a low default risk, and so would probably have a low expected loss. Conversely, a junk bond would have a high probability of loss, and therefore a much higher expected loss. A high expected loss will usually result in a demand by investors for a significantly higher interest rate from issuers to compensate them for the higher level of default risk. This makes it difficult for high-risk issuers to access the capital markets.