What is “Default Risk”?
Default risk, a sub-category of credit risk, is the risk that a borrower will default on or fail to repay its debts (any type of debt). For example, a company that issues a bond can default on interest payments and/or repayment of principal. If the chances of default by a company issuing a bond is higher (i.e the default risk is higher), it will have to compensate investors by offering a higher rate of interest. There are two drivers of default risk – business risk and financial risk.
Key Learning Points
- The risk that the borrower of a loan fails to meet its financial obligations is known as default risk
- Lenders compensate for higher levels of default risk with increased interest rates on the loan
- Credit ratings factor in the business and financial risk of the borrower and provide guidance to lenders on how “credit worthy” the borrower is i.e. how likely are they to default on their payments
- There are three key reasons companies may default on their payments; these include the industry/country it operates in (business risk), company-specific non-financial factors, and the ability of the company to service its debt (financial risk).
- Free cash flows, debt to capital ratio and interest cover ratio are all common financial indicators credit analysts rely upon to determine a borrower’s risk of default in the credit process
Two Drivers of Default Risk
Business risk assesses different factors affecting the external and internal business environment of the borrower. These factors or risks are categorized into:
Country-specific risks: includes changes in the economic environment, institutional or regulatory risks, governance or political risks and risks associated with the functioning of financial systems.
Industry- specific risks: include changes in industry-specific growth trends and market structure, and industry cyclicality.
Company-specific risks: include changes in competitive dynamics, operating efficiency and profitability, a drop in market share, quality of management, corporate governance issues around trust, accountability, and transparency etc.
Financial risk is the quantitative and qualitative assessment of a borrower’s ability to service and repay loans. Financial risk can be assessed by a company’s cash flows, liquidity, earnings, and asset quality.
Issuer Credit Ratings: Quantifying the Default Risk
Issuer credit ratings quantify business and financial risks. Rating agencies, such as Standard & Poor’s (S&P), Moody’s, or Fitch assign credit ratings (which reflect the credit quality of bonds issued by companies). These ratings are intended to assess the risk of default by the issuer.
These credit ratings can be upgraded or downgraded and reflect changes in default risk. A higher (lower) credit rating implies lower (higher) default risk. Individual banks also have their internal mechanism of developing credit ratings.
Given below is a matrix of varying business and financial risks and the resulting credit ratings. The ratings start from AAA (on S&P) or AA+ (on Moody’s), which have the least default risk, and stretch to as low as C, which is barely creditworthy.
|6 (highly leveraged)
All credit ratings above BBB- (on S&P or Fitch) or Baa3 (on Moody’s) are considered as investment grade. An investment grade rating of ÄAA” (highest quality) implies lowest default risk. Based on historical data, it is very unlikely that companies rated A or above will default. BBB- is the lowest investment grade rating.
Ratings below BBB- or Baa3 are considered as sub-investment, high yield or junk grade. All ratings below BBB- or Baa3 reflect a combination of high business and financial risk, and higher default risk.
Indicators of Default Risk (Financial)
Lenders and credit analysts can determine the level of default risk (financial) of a company level using the following financial indicators.
Free Cash Flow
Free cash flow (FCF) tells a bank exactly how much cash is available for a company to repay its debt after all necessary expenses are made.
FCF = EDITDA – Interest – Taxes +/- working capital +/- other operational liabilities – capital expenditure.
Free cash flows near zero or negative could indicate higher default risk. It is important to note in the above formula that interest is subtracted from EBITDA. This is different from unlevered free cash flows and provides more detail into how credit rating agencies review cash flows.
Debt to Capital Ratio
The debt to capital ratio shows a company’s debt as a percentage of its total capital. A higher debt-to-capital ratio indicates higher default risk.
In the example above, company A has a higher debt to capital ratio and consequently higher default risk than company B.
Interest Coverage Ratio
The interest coverage ratio analyzes the relationship between a company’s earnings and its interest obligations. It is calculated by dividing a company’s EBIT by its interest expenses for the period.
The higher the interest coverage ratio, the lower is the company’s default risk. An interest coverage ratio of 1.5 or below raises doubts about the company’s ability to fulfill its interest obligations.
In the example above, the interest coverage ratio is 2.5, which is comfortable.