Default Risk
Candlefocus EditorThe potential for default risk is assessed through credit ratings, which are provided by rating agencies. For example, corporate and government bonds may be rated as either investment grade or non-investment grade. Investment grade bonds are considered to have a lower risk of default, while non-investment grade bonds have a higher probability of default. These ratings are an important factor when determining the risk associated with a particular bond and the associated level of return.
Default risk is also taken into account when evaluating the creditworthiness of consumers. Credit score models such as the FICO system are used to gauge a consumer’s risk of not making a loan payment. This score is also used by other lenders to determine whether or not to approve or extend credit to a particular borrower.
Default risk can be reduced by diversifying investments, diversifying credits and diversifying debt. Diversification of investments will help spread out the risk associated with default and help the lender avoid large losses in the event of a default by a borrower. Diversification of credit entails pooling together a number of loan portfolios, so that the losses from a default on one loan will not create a significant impact on the overall portfolio.
Default risk also needs to be taken into account when assessing cash flows. Companies with a free cash flow near zero or less are likely to have a higher probability of default, as they are not generating the cash needed to make payments on time.
Ultimately, understanding and managing default risk is a critical component of any lender’s strategies, and is essential for minimizing the probability and impact of default on their investments. By understanding default risk, lenders can take the necessary steps to ensure that their investments remain safe and secure.