For consumers, default risk can affect the rates and terms you’ll qualify for if a lender sees you as a high default risk. It could even cause you to be denied a loan. Default risk doesn’t apply only to borrowers who are looking to take out loans. It also relates to companies that issue bonds, and whether they’ll be able to make interest payments on these bonds.
Alternate name: Credit risk
For example, a lender may reject your loan application because you’ve had a bankruptcy in the past year or have low credit scores due to multiple late payments on your credit report. A bond offered by a business may get a low credit rating because it has cash flow issues.
How Does Default Risk Work?
When a borrower takes out a loan, there’s always a chance that they won’t repay it. This default risk is something a lender considers with every borrower. But evaluating a borrower’s default risk is not a straightforward process. Several factors are considered. For individuals, lenders will often look at a borrower’s credit score to determine the individual’s level of risk and what kind of interest rates they should qualify for. A credit score is a three-digit number that evaluates how likely you are to repay your loan and make your payments on time. Your credit score is calculated based on the information in your credit report. This includes your payment history, the number of accounts you have open, and your overall debt levels. For companies, ratings analysts will often look at a company’s free cash flow and financial statements to determine a business’s default risk. Free cash flow is calculated by subtracting a business’s capital expenditures from its operating cash flow. Companies with a poor cash flow could be a higher default risk, and therefore they may receive a lower credit rating.
Types of Default Risk in Investments
Rating agencies evaluate companies and investments to determine their level of risk. The lower the rating, the higher the level of risk. These ratings can be grouped into two different categories: investment grade and non-investment grade.
Investment Grade Ratings
Investment-grade debt has a low risk of default and is seen as more desirable by potential investors. Bonds with a Moody’s credit rating of Baa or a Standard & Poor’s (S&P) rating of BBB or higher are considered investment grade.
Non-Investment Grade Ratings
Non-investment grade securities have a Moody’s credit rating of Ba or lower and are considered high. Non-investment grade companies offer higher interest rates. These are also sometimes called junk bonds.
