When investors build their portfolio of investments, they must take several types of risks. These risks are specific to each type of investment. Therefore, investors need to identify them on time and ensure they can manage those risks. One risk that is common to debt investments is default risk.
What is Default Risk?
Default risk is a risk that a lender does not receive their repayments from a borrower for a given debt obligation. Almost every type of debt instrument or transaction comes with default risks. The higher the default risk of an investment is, the more unlikely it is for lenders to receive their loaned amount. However, higher default risks also accompany higher returns.
Various factors can play a role in determining the default risk of a debt instrument. Usually, a borrower’s credit rating indicates how likely they are to default on their payments. Similarly, a country’s economy or unforeseen events can result in higher default risks. Lenders often consider a borrower’s financial position and performance to determine the level of default risk they undertake.
What is Default Risk of a bond?
A bond is a debt instrument issued by companies or government bodies. A bond issuer is an entity that asks for finance from the investor. Therefore, the company or body issuing the bond is the borrower. The default risk of a bond relates to its issuer. If the issuer cannot repay the loan, the default risk on the transaction will be high.
Several credit rating agencies closely monitor bonds. Similarly, some jurisdictions require issuers to obtain a rating for their debt instruments before issuing them. In these cases, looking at the bond’s credit rating can indicate its default risk. Based on these ratings, bonds may come in two types, including investment-grade and non-investment grade bonds.
How does Default Risk work?
When a lender provides a loan, there is always a chance that the borrower fails to repay the loan. When providing these loans, lenders consider the debt’s default risk. Default risk does not apply to investors the provide other types of investments, such as equity. It is because, with those investments, investors do not expect repayment.
Similarly, default risk only applies to lenders. It does not extend to borrowers. However, borrowers are the reason behind the existence of default risk. Therefore, lenders need to assess a borrower properly before providing them with debt. For most institutional lenders, this assessment comes as a part of their risk management process.
However, the initial assessment does not fix the default risk on the debt. This risk may fluctuate due to various external factors. These may include political, economic, legal, or other factors. It may also include internal factors related to the borrower. For example, a cash flow problem with the borrower can increase the default risk on all of their debt obligations.
The default risk of bonds is also similar to any other debt obligation. However, the lenders or investors may not be of an institutional nature. Despite that, issuing entities provide resources for borrowers to gauge their default risk for bonds.
Default risk is the risk that a borrower does not comply with debt repayment obligation. Every debt instrument, including bonds, comes with default risk. For lenders, it is crucial to assess these risks and make decisions accordingly.