Behind every investment is a company (or government in the case of bonds) that has bills to pay. A well run company keeps those expenses in check and paid on time. It even carries an acceptable amount of debt too. But what happens to your investment when that company takes on too much debt? Or it can’t pay its bills anymore? A default risk premium is built into the price of every investment to cover this risk.
Default risk or credit risk is just one more obstacle investors must consider. Banks do it when you take out a loan. Credit card companies do it when you apply for a new card. As an investor, you need to consider it too. If a company can’t pay its bills, it won’t be in business long enough for you to make money.
What Is Default Risk?
Default risk is the chance that a company or person won’t be able to make payments on their debt obligations. Both the company and the lender are exposed to this risk.
Lenders will charge a higher interest rate to companies with a higher risk of default. Which raises the cost of borrowing for the company. This premium must be built in to make the investment worth the added risk to the lender.
Adding A Default Risk Premium
We see it with people who have bad credit. They end up paying a higher interest rate on loans. Because there is a higher chance the bank won’t get their money bank.
The same concept works when investing. If you were the bank, would you expect a higher return on your money if there was a bigger risk of not getting paid back? Of course!
When you invest in bonds and stocks, a risk premium is added based on the chance that company goes bankrupt. The default risk premium should be high enough to offset the extra risk involved. Though, most of the time it’s best to avoid taking the risk altogether.
For bonds this means a higher interest rate, which leads to a lower priced bond. The default risk premium is found by taking the difference between the interest rate and the risk free rate (generally the interest rate on Treasury bills).
For stocks this means a lower share price to reflect the added risk. If the company does fail, investors are usually the last to get paid.
Who Gets Paid First
Nobody likes getting stuck holding the bag. When bankruptcy and default are being discussed, investors are usually the last to get paid. The order of who gets paid first looks like this:
- Secured Creditors – Take the least amount of risk. Secured loans are backed by collateral and are the first to get paid.
- Bondholders – Get the next crack at any money left once secured creditors are paid. Since companies agree to pay bondholders their principle plus interest payments, they get priority over shareholders. Most of the time this amounts to pennies on the dollar.
- Stockholders – Take the most risk. Even though a shareholder is considered an owner, they are the last to get paid. But there’s usually no money left at this point. Just avoid stocks of companies with a high risk of default.
While many investments can look great at first, digging into the financial statements will show an excessive amount of debt and not enough earnings to pay it off. A little research will help you avoid these default risk traps.