What is Default Risk?

Also known as default probability, default risk is the probability that a borrower won’t pay back debt payments on time. This may include interest payments and principal on loans, bonds, or credit cards. Default risk is a major factor in credit risk and helps lenders determine whether or not to approve a loan.

How Default Risk Works

Every time a lender gives someone a loan, there is a level of risk involved. Default risk is used to determine whether lenders approved a loan and can also determine the interest rate the borrower gets.

When the default risk is high, lenders usually have to pay higher interest rates. This helps to offset some of the risk for lenders. For example, someone with a low credit score who is approved for a mortgage or personal loan may be subject to a higher interest rate than someone with a higher score. The same may apply to other loans like a car loan. That way, if they default on their debt obligations, the lender can still recoup some of the loss due to those higher payments.

Default Risk In Investing

When an investor takes out government or corporate bonds, there is risk involved as they’re lending money to a bond issuer with hopes that they’ll receive their principal and interest back. When assessing the default risk, they may also evaluate whether the interest rate the bond issuer is offering matches the risk they’re taking.

When it comes to bonds, the risk isn’t always clear, especially with corporate bonds. They are affected by factors like economic and company performance, which means the risk can fluctuate depending on external factors.

Measuring Default Risk

There are a range of strategies that can be used to measure default risk. Those strategies look different when assessing corporations versus individuals. Here’s a brief breakdown of how default risk is measured with both.

Corporations and Governments
It is possible to use tools like credit rating agencies to assess how risky a corporate bond issuer is. These organizations give bond issuers credit ratings, which can be used to assess how likely a corporate bond issuer is to repay their debt. Corporations and governments with lower ratings usually carry more risk. There are names for ratings provided by these agencies, which are investment grade ratings and non-investment grade ratings. The former have a lower risk of defaulting on a loan, while the latter are riskier.

Examples of leading organizations that provide this information include Standard & Poor’s (S&P), Moody’s, and Fitch Ratings. When choosing credit rating agencies, it may be ideal to pick ones that are registered as a Nationally Recognized Statistical Ratings Organization or NSROs since they are recognized by the U.S. Securities and Exchange Commission.

Individuals
Credit reports are the primary way lenders assess an individual borrower’s risk. These reports comprise a range of information relating to an individual’s payment history, bankruptcies, debt, credit utilization, and their credit score among other information. It’s a good indicator of how reliable the borrower is and usually determines whether they’ll be granted a loan or not.

Before buying bonds from an issuer it’s good practice to research and check their track record when it comes to repaying debt. While all investments carry risk, you want to minimize that risk as much as possible.