Default risk is the uncertainty a lender faces about whether a borrower will meet their debt obligations, such as making necessary payments on a loan, a bond, or a credit card. Lenders and investors encounter default risk with nearly every form of credit offering. Typically, a higher default risk entails a higher interest rate for the borrower.
Key Insights
- Default risk pertains to the probability that a borrower won’t fulfill their debt obligations to a lender.
- It can be assessed for consumers through credit reports and scores.
- Companies and governments, as well as the bonds they issue, are evaluated for default risk by rating agencies.
- Higher default risk generally leads to higher interest rates for borrowers.
Determining Default Risk
Whenever credit is extended, there exists a chance that the loan or part of it won’t be repaid. Default risk signifies this probability. It applies both to individuals and to companies that utilize loans or issue bonds.
Lenders consider default risk for their lending decisions and interest rate settings. Investors factor in default risk when deciding to purchase a company’s or a government’s bonds, determining whether the potential returns justify the risk.
Tools for Gauging Default Risk
Standard tools for measuring default risk include FICO credit scores for consumers and independent ratings for corporate and government debt. Credit ratings are crafted by organizations such as Standard & Poor’s, Moody’s, and Fitch Ratings.
Economic Influence on Default Risk
Broad economic forces can shift corporate default risk, alongside a company’s specific financial situation. For instance, during an economic recession, many companies might struggle with revenue and earnings, affecting their capacity to make interest payments and repay debt. Companies may also experience increased competition and reduced pricing power, influencing their financial stability similarly.
Evaluating a Company’s Default Risk
Lenders scrutinize a company’s financial statements and leverage various financial ratios to judge their debt repayment probability.
Financial Metrics to Watch
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Free Cash Flow: This is derived by subtracting capital expenditures from operating cash flow. Companies utilize free cash flow for debt and dividend payments. Values near zero or negative might signal heightened default risk.
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Interest Coverage Ratio: Calculated by dividing earnings before interest and taxes (EBIT) by periodic debt interest payments. A higher ratio suggests ample income to cover interest obligations, indicating lower default risk. Moreover, assessing via earnings before interest, taxes, depreciation, and amortization (EBITDA) offers a pure cash-based perspective.
Role of Rating Agencies
Agencies evaluate corporate debt scores, dividing them into major categories: investment grade and non-investment grade (speculative or junk). Investment-grade debt, carrying lower default risk, is favored by investors and consequently demands lower interest rates. Non-investment-grade debt presents higher yields due to elevated default probabilities.
For instance, Standard & Poor’s denotes investment-grade bonds with AAA, AA, A, or BBB ratings, while anything ranked BB or lower is deemed speculative.
Important: In August 2023, Fitch Ratings downgraded the long-term ratings of the United States to “AA+” from “AAA” due to fiscal deterioration projections, mounting government debt, and governance issues impacting debt limit resolutions.
Assessing an Individual’s Default Risk
Credit bureaus gather and sell data on consumers in the form of credit reports to prospective lenders. These reports illustrate the reliability of consumers in settling their dues. A history of prompt bill payments typically signals lower future risk.
Key Factors Influencing Credit Scores
- Bill Payment History: A primary factor in scoring, consistent on-time payments hint at a lower default risk.
- Credit Utilization Ratio: Represents the proportion of outstanding debt relative to total available credit. For instance, a $10,000 debt against a $20,000 credit limit equates to a 50% utilization ratio, with scores generally penalizing ratios above 30%.
Credit scores generally span 300 to 850, with scores above 670 deemed good. Lower scores usually lead to higher interest rates or difficulty obtaining credit, while higher scores garner better terms and larger limits.
Consequences of Defaulting on a Loan
Consequences differ based on loan type and lender policies. For secured loans, the lender may seize the collateral, like a vehicle or a business asset. For unsecured debt, like credit cards, lenders might file lawsuits or transfer the debt to collection agencies.
Future Credit After Default
Defaulting drastically diminishes attractiveness to future lenders, potentially preventing borrowing or resulting in severely high-interest rates. For individuals, a default can linger on credit reports and impair credit scores for up to seven years.
Delinquency Versus Default
Debt is classified as delinquent when a single payment is missed. Default follows after multiple missed payments, varying by loan type and lender. Although both are detrimental, defaults have longer-lasting effects on credit history.
Summary
Lenders and investors utilize distinct measures to forecast the default probabilities of individuals, companies, or governments. The higher the default risk, the greater the expected compensation in the form of elevated interest rates.
Related Terms: credit score, investment grade, junk bonds, credit report, interest coverage ratio.
References
- S&P Global. “Intro to Credit Ratings”.
- Fitch Ratings. “Fitch Downgrades the United States’ Long-Term Ratings to ‘AA+’ from ‘AAA’; Outlook Stable”.
- Experian. “What Is a Good Credit Utilization Rate?”
- Equifax. “What Is a Good Credit Score?”
- Equifax. “What Happens if I Default on a Loan or Credit Card Debt?”
