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Default Risk

Understand the Concept of the Default Risk Premium

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Default Risk Definition

The inclusion of the default risk premium in lending is to provide more compensation for a lender in proportion to the additional assumed risk.

Default risk is a major component of credit risk that captures the likelihood of a company failing to make timely payments on its financial obligations, namely:

  • Interest Expense – The periodic payments to the lender throughout the term of the debt (i.e. the cost of debt financing).
  • Mandatory Amortization – The required paydown of the debt principal during the lending period.

Furthermore, the default risk premium refers to the incremental return required by lenders in exchange for assuming more risk by providing debt capital to a specific borrower.

Simply put, the default risk premium is defined as the difference between the interest rate pricing on a debt instrument (e.g. loan, bond) and the risk-free interest rate.

Therefore, one method for lenders to earn greater yields for providing capital to borrowers with higher risk profiles (i.e. chance of default) is by demanding higher interest rates.

Default Risk and Interest Rate Pricing Relationship

All forms of investing – whether it be in equity or debt securities – boil down to a trade-off between risk and return.

That said, if there is more risk taken on by the investor, there must be more returns in exchange.

All else being equal, the relationship between default risk and the pricing on debt is as follows:

  • Low Default Risk → More Favorable Lending Terms (i.e. Lower Interest Rates)
  • High Default Risk → Less Favorable Lending Terms (i.e. Higher Interest Rates)
Default Risk and Equity Considerations

A higher likelihood of default not only increases the risk to debt investors but to equity shareholders, as well.

If a company defaults on financial obligations and undergoes forced liquidation, the proceeds from the sale are distributed by order of priority.

Furthermore, all debt is placed higher than both preferred and common equity in the capital structure.

In effect, the relationship between default risk and equity holders is that an increase in default risk causes the cost of equity (i.e. the required rate of return by equity investors) to rise.

Factors Impacting Default Risk

The factors that help lenders and debt investors measure the implied default risk premium of a company are quite extensive.

For example, there are country-specific risks such as political structures as well as industry-specific risks like regulations that can impact the default risk of a company.

However, for our purposes, we’ll focus on company-specific risks in the subsequent sections.

Leverage Ratios

First and foremost, the leverage ratio of the company is one of the most important attributes considered by lenders evaluating the default risk of a company.

In short, even the most well-run companies with a track record of consistent cash flow generation and profitability can become financially distressed if the debt burden is too significant.

By calculating the leverage ratio of a company and comparing it to its estimated debt capacity (i.e. the maximum debt burden that a company’s cash flows could reasonably handle), the amount of new debt capital to provide (and the pricing) can be determined.

Alternatively, the lender could also decide that the default risk is too significant and decide to not proceed with the financing.

The lower the leverage ratio of the company, the more “room” there is for the company to borrow debt capital. Since fewer financial obligations exist on the balance sheet, the default risk is reduced (and vice versa).

As a side note, the leverage ratio of a company (and its comparables) can often be a useful proxy for assessing the cyclicality risk of the industry and the market positioning of the company (i.e. market share).

Examples of Leverage Ratios
  • Leverage Ratio = Total Debt / EBITDA
  • Senior Leverage Ratio = Senior Debt / EBITDA
  • Net Debt Leverage Ratio = Net Debt / EBITDA

Interest Coverage Ratios

Another diligence consideration is the capability of the company to meet interest payments on schedule.

The primary method to evaluate this is by calculating the interest coverage ratio – which is most commonly calculated by dividing a company’s operating income (EBIT) by its interest expense amount.

The interest coverage ratio counts the number of times that a company’s operating cash flows could hypothetically pay off its interest expense amount.

In general, the higher the coverage ratio, the lower the default risk, as the company has sufficient cash flows to meet its interest expense payments.

Examples of Interest Coverage Ratios
  • Interest Coverage Ratio = EBIT / Interest Expense
  • Cash Interest Coverage Ratio = EBIT / (Cash Interest Expense – PIK Interest)

Profitability Metrics

Another consideration is the profitability of the company, as companies with higher profit margins tend to have higher free cash flows (FCFs).

Companies with more FCFs are substantially more likely to pay off all of their financial obligations.

Therefore, companies of higher profitability, especially if operating in a non-cyclical industry, are viewed as having lower default risk.

Examples of Profitability Metrics
  • Gross Profit Margin = Gross Profit / Revenue
  • Operating Margin = EBIT / Revenue
  • EBITDA Margin = EBITDA / Revenue
  • Net Margin = Net Income / Revenue

Liquidity and Solvency Ratios

The final component we’ll discuss is the liquidity of the company (i.e. the amount of collateral owned by a company).

When evaluating potential borrowers and their default risk, lenders can determine their creditworthiness by utilizing liquidity and solvency ratios.

  • Liquidity Ratios – Measure how much liabilities, namely near-term current debt obligations, can be paid off if the company underwent a hypothetical liquidation.
  • Solvency Ratios – Measure the extent to which a liquidated company’s assets can pay off its total liabilities, but with a longer-term time horizon (i.e. assessment of long-term viability).

Since liquidity and solvency ratios are calculated assuming a liquidation scenario, both represent “worst-case” scenario planning – in which lenders view asset-heavy borrowers more favorably due to the assurance that there is enough collateral.

Examples of Liquidity Ratios
  • Current Ratio = Current Assets / Current Liabilities
  • Quick Ratio = (Cash & Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Examples of Solvency Ratios
  • Debt-to-Equity Ratio = Total Debt / Total Shareholders’ Equity
  • Debt-to-Assets Ratio = Total Debt / Total Assets
  • Equity Ratio = Total Shareholders’ Equity / Total Assets
  • Asset Coverage Ratio [(Total Assets – Intangible Assets) – (Current Liabilities – Short-Term Debt)] / Total Debt
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