Default Risk

Default risk is the risk that a borrower will fail to make the payments it is contractually obligated to make, whether interest, principal, or both. It is the specific, most severe element within credit risk: where credit risk covers the full range of ways a lender can be hurt, including downgrades and widening yield spreads, default risk refers narrowly to the chance that the borrower actually stops paying. It applies to any debt, from a corporate or government bond to a consumer loan, and it is the risk that the lender's expected cash flows simply do not arrive.

Default risk and credit risk are related but not identical, and keeping them distinct clarifies both. Credit risk is the umbrella: any loss stemming from a borrower's deteriorating creditworthiness, including a downgrade or a widening spread that lowers a bond's price without a missed payment. Default risk is the specific event at the extreme of that range, the borrower failing to pay. A bond can suffer from credit risk without any default; a default is credit risk fully realized. Two quantities determine what default actually costs. The first is the probability of default, the likelihood the borrower stops paying over a given period. The second is the recovery rate, the share of the owed amount that creditors ultimately get back through bankruptcy, restructuring, or the sale of collateral. Their complement, the loss given default, is the fraction not recovered. Expected loss combines the two: probability of default multiplied by loss given default. This is why a secured lender with strong collateral can tolerate a higher probability of default than an unsecured one, since the recovery rate cushions the loss. Default risk is estimated, never known in advance, through credit ratings, the yield spread the market demands over a risk-free Treasury, and quantitative models. U.S. Treasury securities are the usual stand-in for the near-absence of default risk, which is what makes their yield the baseline every riskier bond is measured against.

Default risk is quantified as an expected loss that combines how likely a default is with how much is lost when one happens.

A hypothetical example. An investor considers a $1,000 corporate bond.

• The market and rating agencies judge the issuer's probability of default at about 2 percent over the coming year.
• If it did default, creditors are estimated to recover about 40 cents on the dollar, so the loss given default is 60 percent.
• Expected loss for the year: 2 percent × 60 percent = 1.2 percent of the bond's value, roughly $12.

To be compensated for that expected loss and for the uncertainty around it, the investor demands a yield above the risk-free Treasury rate. If Treasuries of the same maturity yield 4 percent, the investor might require 5.5 percent or more on this bond, and that extra yield is the market's price for bearing the default risk.

Pros (of taking default risk knowingly)

• Higher default risk comes with a higher yield, so a lender willing to bear it, and to diversify it, can earn more than a risk-free instrument pays.
• Where debt is secured by collateral, a high recovery rate can make even a meaningful probability of default a tolerable exposure.

Cons

• A default can mean losing a large part of the principal, not just forgoing interest.
• The estimates it rests on, ratings, spreads, and models, are opinions and projections that can be wrong, sometimes badly and suddenly.
• Defaults cluster in recessions, so the risk tends to arrive across many holdings at once rather than one isolated issuer at a time.