Default Risk Premium: What It Is and Why It Matters
A default risk premium is considered the additional amount of interest rate that is paid to the lender or investor by the borrower. This financial amount is compensation for the borrower because they have a high credit risk. Ultimately, the default risk premium assumes that the person or business is going to fail to pay back their principal amount in the future. This premium is mathematically described as being the difference between the payable interest rates on the bond and the risk-free rate of return.
Explanation of Default Risk Premium
The DRP (Default Risk Premium) is compensatory payment to the financial lenders or investors if the borrower defaults on their debt for any reason. This is commonly applied to bonds. Any lender can charge a higher premium if there's the chance that the borrower might default in meeting their debt servicing. That includes defaults of recurring interest payments or the principal amount based on the agreed conditions and terms. Ultimately, this acts as the lender incentive to get rewarded because they take on more risk.
Purpose of Default Risk Premium
The lender might assume that the borrower is going to default and not comply with the debt servicing conditions and terms. For example, the financial lender could charge a higher default risk premium if there's a risk of non-payment. Investors who may have poor credit records are going to pay higher interest payments and a higher interest rate to borrow the money they require.
If an adequate default risk premium isn't available, the investor is not going to invest in companies that are highly prone to default. If a particular company shows a lower default risk, this can, in turn, lower the future cost of raising a company's capital. Therefore, those companies are going to get funds with the lower DRP. The U.S. government does not disburse the default premium in most cases. However, it can during unfavorable conditions to help attract more investors and pay those higher yields.
The Default Risk Premium Formula
With the default risk premium, there are two different calculations to get the financial rate of return. It is calculated like this:
The Risk-free Rate of Interest - (minus) Interest Rate Charged by the Lender
Other Components of Interest - (minus) Total Interest Charged
In a sense, the default risk premium is the difference between that risk-free rate of return and the interest rate charged directly by the lender. That interest rate includes these components:
The default risk premium
The Inflation premium
The risk-free rate of return is usually based on a particular asset that poses no risk at all. Default risk premium typically deals with low-grade bonds, such as 10-year U.S. Treasury bonds. Those types of bonds are backed by the United States government. The amount over the rate of the 10-year treasury bond that the investor would prefer to earn on the investment is called the default risk premium.
In most cases, poor credit and credit history determine the interest rate a person receives. Typically, a credit rating shows everything that a person or business had previously defaulted on. That is why the risk-free rate is lower, and the interest payment is higher.
How to Calculate a Premium Default
Default risk premium is based on the estimated return on the bonds. This must be reduced by the risk-free return rate for the investment. To calculate a borrower's DRP for the bonds, the coupon rate of the bonds must be reduced by the risk-free return rate. This is generally understood through the steps shown below:
The rate of return for a risk-free investment must be determined first. The principal amount is going to grow with inflation, though deflation is reduced. The securities are ultimately backed up by the US government. Say right now that the rate of risk-free securities is at 1 percent.
If corporate bonds are to be purchased that offer 10 percent of its annual rate of return, the rate from the treasury must be subtracted first from the corporate bond securities. That means 10 percent - (minus) 1 percent to become 9 percent.
The estimated rate of inflation has to be subtracted from the difference listed above. If the inflation rate right now is estimated at 4 percent, then the value is going to be 9 percent - (minus) 4 percent, making it 5 percent.
If there is any other premium included with the bond-like liquidity premiums, then those premiums must also be subtracted. For example, the bond itself carries a 1 percent liquidity premium. When 1 percent is subtracted from 4 percent, the default risk premium is at 3 percent for this particular bond.
A Real-life Example of Default Risk Premium
In this example, company ABC is issuing some bonds that have a 10 percent annual percentage yield. Right now on the market, the risk-free rate is at 1 percent. Inflation for that year is estimated to be about 3 percent. The maturity and liquidity premiums for the bonds are both at 1 percent. When everything is added together, the sum is 6 percent total. Therefore, this particular bond has a default risk premium equal to about 4 percent. Ultimately, this is the annual percentage yield of 10 percent - (minus) the other interest components of 6 percent.
The other components of interest include:
Factors That Can Determine the Default Risk Premium
Three primary factors can determine the default risk premium. They include:
A person's credit history shows a lender a lot about what they are willing and able to do. A borrower is considered to be trustworthy if he or she has paid their debt on time along with the interest payments. This can be an individual or company. However, to get a lower default risk, the borrower must have a good rating and credit history.
Those with poor credit rarely make it into this category. If a person or company does have a low default risk, then they have access to cheaper loan and bond offerings. This is because the lenders charge a lower DRP from them. They may also see a lower interest rate. Typically, without a good score, it's hard to borrow money from a bank without paying a high interest rate. Debt and financial responsibility have a lot to do with this.
If a company has a poor credit rating and lower-grade bonds, they pay more in default risk premiums. A company's rating is based on its overall financial performance through rating agencies. These rating agencies include S&P, Fitch, and Moody's.
When a company has a better financial performance, it has a better credit rating. This ultimately means that it is a low-risk option, so the DRP is lowered and the credit rating is higher. Therefore, the investor would not necessarily get high returns because there is less risk on the investment. Companies also have to worry about the interest rate.
Profitability and Liquidity
A company's profitability can help the bank know its creditworthiness before it hands out loans. The cash flow is examined extensively to determine if the companies have enough cash to meet all interest obligations. If not, the loans are still given out, but the companies must pay more to have the loan.
Typically, poor business dealings can make for a higher DRP because lenders are more worried about giving companies money. Ultimately, the government decides maturity premiums and how they're paid. The financial market also has a say in this. When a person or business has a high debt ratio, it can be much harder to get a bank loan, no matter the accessible income. Lenders are less likely to help, and the price goes up significantly.
Advantages of a Default Risk Premium
There are many advantages for DRP, though they tend to focus on the investors/investment and not the business or individual. Here they are:
With higher DRPs, the financial market must compensate the investor for taking on a greater risk and investing in those companies.
A novel or risky business investment can offer above-average returns. That means the borrower can use that as the earning reward for the investors to take on that investment risk.
If a particular asset is considered high-risk, there is a greater required return from the asset.
DRP can help assign a relative risk rating for particular components for the investor.
DRP also helps determine the risk level for a lender or an investor if the borrower happens to default on the business loan.
The financial market must focus on the money going in and out. Typically, businesses with high debt may find that it's harder for the bank to help them with appropriate loans. On top of that, the price is higher for the borrower, and the investor sees that money.
Any financial investment requires the right investors. A company often has to worry about financial interests, and the investment could go south if the business owner doesn't pay what it owes to the investors each time. Typically, a debt is in good standing when it is being paid on time, including interest rates.
It's often best for individuals and business owners to work with a financial advisor, especially if they have questions about DRP or other financial terms such as an in-kind transfer. That way, they get the answers they need to those hard-to-ask questions.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Stratos Wealth Partners, LTD., a registered investment advisor. Stratos Wealth Partners, LRD. The Kelley Financial Group, LLC are separate entities from LPL Financial.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. The content is developed from sources believed to be providing accurate information.