Default risk refers to the potential that a borrower fails to make interest and principal payments. Borrowers with a higher chance of defaulting pay a higher interest rate.
Investors in equity may expect a return, but this is not certain. There is the risk that the return will be lower but also the opportunity that the return will be higher.
Investors in debt can expect an agreed return; however, there is the risk that the borrower cannot deliver that promised return. Unlike an equity investment though, there is no opportunity that the debt investor will receive more than the guaranteed return.
Default risk factors
Three key factors determine the debt default risk:
- The firm’s ability to generate operating cash flow
- The financial obligations of the firm; the higher the interest and repayment burden as a percentage of cash flow, the higher the default risk
- The volatility in cash flows; the more stable the cash flows, the lower the default risk
Independent rating agencies, such as Standard & Poors (S&) and Moodys, measure default risk. The agencies then rank investments according to the default risk, for example, an S&P AAA rated investment indicates the investment has the lowest default risk.
The agencies measure default risk using company financial ratios, such as pretax interest coverage, free operating cash flow to total debt, total debt to debt and equity, and operating income as a percentage of sales.
The difference between the interest rate on a default-free government bond and bond with default risk is called the default spread. A bond with a higher rating will have a lower default spread compared to lower rated bond.
Simon is a CA Business Valuation specialist, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.
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