What is a 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.
Default Risk Premium Formula
DSR formula is represented as below :
DRP = Interest Rate Charged by Lender – Risk-Free Rate of Interest
DRP = Total Interest Charged – Other Component Of Interest
DRP is the difference between the Risk-Free Rate and the Interest Rate charged by the lender. The interest rate comprises the following components – Inflation premium, maturity premium, liquidity premium , risk-free rate, and DRP. The risk-free rate is based on an asset that possesses no risk. DRP generally deals with treasury bonds, as the US government backs these bonds. The default risk premium is the amount above the rate of treasury bonds that any investor would like to earn on an investment.
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.
What determines the default risk premium?
Default risk premiums essentially depend on a company or an individual’s creditworthiness. There are a variety of factors that determine creditworthiness, such as the following:
If a person or company has regularly made interest payments on time on past obligations, it signals to lenders that the entity is trustworthy. If the entity has taken on incremental debt obligations (i.e., increasing amounts of debt every time debt was taken on) and managed to stay on top of interest payments, lenders will consider the entity more trustworthy as well.
A good credit history inclines lenders to allow the entity to borrow more money, and at lower interest rates. Because the entity’s probability of default is relatively low, the default risk premium charged will be correspondingly low. The opposite is also true. A poor credit history will make lenders demand a higher default risk premium.
Liquidity and profitability
Lenders may also examine an entity’s financial position. For example, if a business is applying for a loan from a bank, the bank might examine some of the business’ recent financial statements. If the business seems to be generating reliable month-over-month revenue, effectively managing costs and producing profits, banks are more inclined to charge a lower default risk premium.
Examining the business’ balance sheet and cash flow statement provides insight into the business’ liquidity and ability to meet monthly interest payment obligations. Conversely, poor liquidity and profitability will solicit a higher default risk premium.
Assets make borrowers attractive to banks, as the loans can be collateralized against them. For example, if a business owns a $5-million building and would like to take on a $5 million loan to finance its operations, a bank might use the building as collateral. In such a situation, the bank would be able to claim ownership of the building in the event that the business was no longer able to make the loan repayments.
Collateralization commonly underpins mortgage agreements. Banks can take ownership of a property if the borrower fails to make the loan payments. Owning lots of collateralizable assets usually enables borrowers to secure larger loans, but may not directly affect the default risk premium.
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.
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 Default Risk Premium
- With a high default risk premium, the market compensates investors more for undertaking greater risk by investing in such companies.
- Novel and risky business investments offer above-average returns, which the borrower can use as an earning reward for investors on investment risk.
- The riskier a particular asset is, the greater is the required return from that asset.
- DRP helps assign a relative risk rating to a particular asset for the investor.
- DRP helps determine the level of risk an investor or lender has to undergo if a borrower defaults on the loan.
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.