What Is a Default Probability?

What Is Default Probability?

Default probability is the likelihood over a specified period, usually one year, that a borrower will not be able to make scheduled repayments. It can be applied to a variety of different risk management or credit analysis scenarios. Also called the probability of default (PD), it depends, not only on the borrower's characteristics but also on the economic environment.

Creditors typically want a higher interest rate to compensate for bearing higher default risk. Financial metrics — such as cash flows relative to debt, revenues or operating margin trends, and the use of leverage — are common considerations when evaluating the risk. A company's ability to execute a business plan and a borrower's willingness to pay are sometimes factored into the analysis as well.

Understanding Default Probability

People sometimes encounter the concept of default probability when they purchase a residence. When a homebuyer applies for a mortgage on a piece of real estate, the lender makes an assessment of the buyer's default risk, based on their credit score and financial resources. The higher the estimated probability of default, the greater the interest rate that will be offered to the borrower. For consumers, a FICO score implies a particular probability of default.

For businesses, a probability of default is implied by their credit rating. PDs may also be estimated using historical data and statistical techniques. PD is used along with "loss given default" (LDG) and "exposure at default" (EAD) in a variety of risk management models to estimate possible losses faced by lenders. Generally, the higher the default probability, the higher the interest rate the lender will charge the borrower.

High-Yield vs. Low-Yield Debt

The same logic comes into play when investors buy and sell fixed-income securities on the open market. Companies that are cash-flush and have a low default probability will be able to issue debt at lower interest rates. Investors trading these bonds on the open market will price them at a premium compared to riskier debt. In other words, safer bonds will have a lower yield.

If a company's financial health worsens over time, investors in the bond market will adjust to the increased risk and trade the bonds at lower prices and therefore higher yields (because bond prices move opposite to yields). High-yield bonds have the highest probability of default and therefore pay a high yield or interest rate. At the other end of the spectrum are government bonds like U.S. Treasury securities, which typically pay the lowest yields and have the lowest risk of default; governments can always print more money to pay back debt.