Agencies such as Moody’s and Standard & Poor’s rate corporate bonds according to the likelihood that the bond issuer can generate the cash needed to repay the debt through the sale of goods and services, or the sale of company assets.
From the company's perspective, the higher a company’s credit rating, the lower the company’s default risk and the lower the default risk premium the company will pay a lender. From the investor's perspective, the lower the company’s default risk, the lower the bond’s yield.
Components of an Interest Rate
The bond investor’s minimum required return is based on five elements:
- Default Risk Premium: A premium to compensate an investor for the likelihood the bond issuer will default on the obligation.
- Liquidity Premium: A premium that compensates an investor for investing in a non-liquid asset.
- Maturity Premium: A premium to compensate an investor for the risk that results from a bond’s maturity date being many years in the future.
- Projected Inflation: A premium to compensate for the devaluation of currency over time.
* Risk-Free Rate: The rate of return an investor expects on a risk-free security, such as a T-bill.
A borrower pays a lender a default risk premium to compensate the lender for assuming the risk that the borrower will default on the debt. The rate the borrower pays varies according to the level of risk the loan poses to the lender.
The default risk premium formula is the difference between the risk-free rate and the interest rate attached to a borrower's debt instrument:
Asset or Investor Return - Risk-Free Return = Default Risk Premium
Function of the Default Premium
Assume a company with a poor credit rating issues junk or non-investment-grade bonds, the interest rate for which will include a default risk premium. The default premium compensates investors for assuming the risk that the company will default on the debt.
The greater a company’s revenue stream and collateral, the higher its credit rating and the lower the default premium its lenders will require. In like manner, the smaller a company's revenue stream and the less its collateral, the lower its credit rating and the higher the default premium a lender will require.
Determinants of Default Risk Premium
A default risk premium reflects a company’s creditworthiness. Three factors determine creditworthiness.
Borrower's Credit History
A lender considers a borrower to be trustworthy if that borrower consistently makes payments on debt obligations. Also considered is the borrower's ability to pay debt that increases in its amount over time. A poor credit history will lead to a higher default risk premium.
Liquidity and Profitability
Before approving a loan, a lender will examine the borrower’s financial position. This process will include a review of the borrower’s financial statements, including the borrower’s balance sheet and cash flow statement to confirm that the organization’s liquidity is such that it will meet its obligations.
Assuming the borrower generates month-over-month revenue while managing costs and producing profits effectively, a lender will likely charge a relatively low default risk premium. If the opposite is true, the lender will impose a higher default risk premium.
Borrower's Asset Ownership
A borrower with assets is more attractive to a lender than one without them because those assets can serve as collateral for loans. For instance, a business might commit a plant and equipment as collateral for a loan to finance its operations.
Bonds and Default Premiums
Theoretically, there is zero risk that the U.S. Treasury will default on the securities that it issues. Consequently, the government is unlike other borrowers in that, in most circumstances, it does not pay a default premium on its debt. In tumultuous times, however, the creditors of the U.S. government require that the U.S. Treasury offer higher yields to borrow the cash the government requires to operate.
The default premium, therefore, is the yield on a bond issuance that’s in excess of the yield of a Treasury bond of similar coupon and maturity. For example, the yield of a company’s 10-year bond will exceed that of a U.S. Treasury bond with a 10-year maturity.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.