DEFAULT

A default on a loan or bond issue occurs when the borrower fails to make interest or principal payments when they are due. Default risk affects the interest rate charged on a debt instrument. The greater the default risk, the higher the interest rate charged by lenders. Investors do not have to worry that the U.S. Treasury will default on its debt. Federal governments do not declare bankruptcy, they simply print more money. As a result, Treasury securities carry the lowest interest rates on taxable securities.

Default risk is a function of a number of different variables. It is directly related to the firm's operations. An increase in the riskiness of a borrower's operating cash flows will increase the likelihood of default. On the other hand, a firm operating in a risky environment will be less likely to default if the debt service payments relative to its operating cash flows are modest. In addition, the longer the firm has been operating without creditors incurring losses, the lower the default risk. The longer the firm has sustained operations, the lower the default risk.

MEASURING DEFAULT RISK

The difference in the promised yield between a corporate bond and a government bond with the same coupon and maturity is called the default premium. The greater the chance that the company will experience financial distress, the higher the default premium required by investors. The default risk premium is typically measured by comparing the yield on a long-term Treasury bond with a long-term corporate security that is comparable to the Treasury security in all material respects. The difference in the two yields serves as a proxy for the default premium.

There is a cyclical nature to default premiums. In general, the yield spread narrows during periods of economic prosperity, and widens during economic downturns. A rationale for this phenomenon is that investors may be more willing to take on additional risk during times of prosperity, thus requiring less yield from lower-rated bonds. On the other hand, during economic downturns, investors are more interested in security, and thus require higher yields from riskier, lower-rated bonds.

Patterns in default rates reflect a firm's life cycle. Lower-rated issuers—smaller, younger, and more heavily leveraged firms—tend to have wider credit spreads that narrow with maturity. Higher-rated firms—more mature and stable—tend to have narrower credit spreads that widen with maturity.

DEFAULT AND BOND RATINGS

To assist bond investors in making their assessment about the future payment prospects of a particular bond issue, ratings services such as Standard & Poor's and Moody's Investors Services assess the quality of various bonds by measuring default risk. Bond ratings have provided a good guide in gauging the risk of default. Default rates are very low for higher-rated bonds, and increase as the bond ratings decline. The higher the rating, the smaller the number of issues that subsequently default. With lower ratings, the default percentage increases dramatically. Thus, the default premium widens as the ratings decrease.

A number of studies have examined the relationship between bond ratings and the financial variables of firms. These studies have found higher debt ratings assigned to the bonds of firms that have lower debt ratios, higher interest coverage ratios, higher returns on assets, lower variability in earnings per share over time, and lower use of subordinated debt. Accordingly, the bonds of firms having these characteristics would be expected to have a lower risk of default.

Once a bond rating has been established, it can change because of either an improvement or deterioration in the company's fortunes. In recent years, the number of downgraded bond ratings has exceeded the number of upgradings. The inclination of a deterioration in credit quality reflects to a certain extent the greater use of financial leverage as a result of leveraged buyouts and corporate restructurings.

Since 1971 there has been a prolonged deterioration in overall corporate credit quality. The default rates associated with different ratings over time have clearly increased since 1971. Since January 1971 the five-year cumulative default rate has increased within all ratings categories. For speculative grade classes, the default rate has increased by approximately three times; for investment grade issues, the increase has been less pronounced. Although the five-year default rates rose during the growth of the junk bond market, the deterioration in credit quality was common to both investment grade and speculative issues. The increase in default rates is also associated with the deterioration in leverage ratios within each rating class that started during the mid-1980s. The median earnings to fixed charge ratio decreased and the ratio of debt to assets increased for bonds in the BBB, BB, and B ratings classes.

The rating agencies do not intend their ratings to suggest the same default probabilities at all times. They are reluctant to make ratings changes based on cyclical considerations, although the occurrence of defaults within ratings categories clearly increases during recessions. Therefore, long-term default probabilities are assumed to exhibit relative stability for frequencies longer than the business cycle. Legislators and regulators of the financial markets presume such stability when they set specific ratings levels into law and regulation.

DEFAULT AND OPTION PRICING THEORY

Default has also been analyzed in an option pricing framework. Shareholders possess an option to default, which will be exercised only if the firm's liabilities are greater than the value of its assets. Due to shareholders' option to default, a corporate bond can be viewed as equivalent to the combination of a default free Treasury bond less the value of a corporate option to default. As the value of the firm increases, for a given amount of debt, the value of the option to default becomes smaller. If the market value of the firm declines or its assets become riskier, however, then the option to default increases in value.

There are three primary ways in which shareholders can increase the value of the option to default and therefore transfer wealth from bondholders to shareholders. First, a company can make an unexpectedly large dividends distribution to its shareholders resulting in an increase in the debt to equity ratio and less collateral to meet bondholders' claims. Second, by issuing more debt having equal or more senior priority, the company dilutes the amount of equity available to meet the claims of the old bondholders. Since the original bonds are now riskier, their price declines. Third, by increasing business risk through the adoption of high-risk projects, the value of existing bonds drops.

DEFAULT EXPERIENCE

The rough consensus is that bond portfolios might lose I to 2 percent of their value each year through default. An analysis of all defaults on straight debt during the 1977-88 period reveals that annual default loss rates averaged 1.63 percent, with a principal loss of 42.7 percent. Low-grade (high-yield) bonds have historically had annual default rates of approximately 3 percent. The default experience for high-yield bonds, however, increased markedly during the 1989-90 period.

Financially distressed firms will attempt to fend off defaulting on their obligations and avoid liquidation of the firm's assets. Two alternative out-of-court options are an extension and a composition. In an extension, creditors agree to accept delayed payments from the firm. In a composition, the creditors receive a pro rata settlement (proportionate allocation) of their claims. An additional option is to undertake an exchange offer whereby a new package of securities —often including equity—is exchanged for the existing bond issue. Distressed exchange offers reduce the measured rate of bond defaults.

Empirical work indicates that default rates on low-grade bonds increase with the age of such a bond. Some studies, however, failed to account for the fact that default rates for all bonds, irrespective of age, depend critically on prevailing economic conditions. Further analysis indicates that a significant portion of the higher default rates attributed to the age of a bond might better be attributed to general economic conditions than to age itself. There are more defaults in some years than in others, irrespective of bond age. When this systematic variation in defaults is accounted for, the statistically significant relation between bond age and default rate is greatly diminished.

LOAN PORTFOLIOS AND DEFAULT RISK

Loan portfolio diversification to limit default risk—by borrower, type of loan, industry, or geography—is a major objective of bank management. By increasing the number and diversity of borrowers in a loan portfolio, bank management reduces the importance of any single borrower to the loan portfolio. This, in turn, decreases the potential impact of a loan loss from a single borrower on that portfolio. In addition, the likelihood of several borrowers defaulting at the same time decreases under diversification, which also increases the predictability of loan losses and reduces potential fluctuations in future bank earnings.

Diversification may result in a lower average credit quality of the loan portfolio. This normally will be offset by higher returns on the portfolio due to the direct relationship between risk and return. Undesirable side effects associated with loan portfolio diversification, however, include higher portfolio origination and servicing costs.