What are your thoughts about the relative level of default risk rates? Default risk is generally the added interest rate load, over and above Treasuries, that measure the relative default risk of bonds. Is the risk charge for risk bonds such as corporates, mortgages, or international bonds going to increase or decrease?
Default risk is the chance that a company or individual will be unable to make the required payments on their debt obligation. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. A higher level of risk leads to a higher required return, and in turn, a higher interest rate.
KEY TAKEAWAYS
Understanding Default Risk
Default risk can be gauged using standard measurement tools, including FICO scores for consumer credit, and credit ratings for corporate and government debt issues. Credit ratings for debt issues are provided by nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's (S&P), Moody's, and Fitch Ratings.
Default risk can change as a result of broader economic changes or changes in a company's financial situation. Economic recession can impact the revenues and earnings of many companies, influencing their ability to make interest payments on debt and, ultimately, repay the debt itself. Companies may face factors such as increased competition and lower pricing power, resulting in a similar financial impact. Entities need to generate sufficient net income and cash flow to mitigate default risk.
In the event of a default, investors may lose out on periodic interest payments and their investment in the bond. A default could result in a 100% loss on investment.
To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default risk.
Special Considerations
Lenders generally examine a company's financial statements and employ several financial ratios to determine the likelihood of debt repayment.
A technical default can occur if a debt can be repaid, but certain conditions of the loan cannot be met.
Free cash flow is the cash that is generated after the company reinvests in itself and is calculated by subtracting capital expenditures from operating cash flow. Free cash flow is used for things such as debt and dividend payments. A free cash flow figure that is near zero or negative indicates that the company may be having trouble generating the cash necessary to deliver on promised payments. This could indicate a higher default risk.
The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its periodic debt interest payments. A higher ratio suggests that there is enough income generated to cover interest payments. This could indicate a lower default risk.
Types of Default Risk
The credit scores established by the rating agencies can be grouped into two categories: investment grade and non-investment grade (or junk). Investment-grade debt is considered to have low default risk and is generally more sought-after by investors. Conversely, non-investment grade debt offers higher yields than safer bonds, but it also comes with a significantly higher chance of default.
What are your thoughts about the relative level of default risk rates? Default risk is generally...
Which of the following equations is NOT correct? Quoted rate = quota risk-free rate + default risk premium + liquidity premium + maturity risk premium Quoted interest rate minus real risk-free rate = Inflation premium Maturity risk premium + marketability premium = Nominal rate minus quoted risk-free rate Maturity risk premium + marketability premium + default risk premium = Nominal rate minus quoted risk-free rate You are the chief financial officer (CFO) of a regional bank in New Orleans. As you...
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a. If the level of interest rates increase (possibly due to an increase in expected inflation rates) for the overall economy, how do bond prices of existing, outstanding bonds react, and why? b. In other words it is a kind of debt security under which the seller is owed to the ... But higher the default risk premium, the more will be the required return 'r'. ... A 10-year bond has a face value of $1,000 with a coupon rate...
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Means of change y ou 1) What is the real will the band wa esta bond that 15 per year? s s) b) -8% 17) According to Say's Law, total output is a function of a) Labor; Utility b) Utility: Capital e) Technology: Capital d) Labor: Capital 18) When hond investors take Interest Rate Risk into consideration before purchasing bonds, they generally find that this risk tends to _when market interest rates are higher, Whe bond investors take Duration Risk...
3. Calculating interest rates The real risk-free rate (r) is 2.80% and is expected to remain constant into the future. Inflation is expected to be 3.20% per year for each of the next four years and 2.00% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.10 x(t-1)%, where is the security's maturity. The liquidity premium (LP) on all Tahoe Hydroponics's bonds is 0.60%. The following table shows the current relationship between bond ratings and default risk premiums...
Assignment 06 - Interest Rates 4. Calculating interest rates Aa Aa The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year for each of the next two years and 5% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t - 1)%, where t is the security's maturity. The liquidity premium (LP) on all Global Satellite Corp.'s bonds is 0.55%. The following table shows the current relationship...
Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 6% per year for each of the next three years and 5% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t – 1)%, where t is the security’s maturity. The liquidity premium (LP) on all Rinsemator Group’s bonds is 1.05%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): Rating...
3. Calculating interest rates The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 3% per year for each of the next two years and 2% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t - 1)%, where t is the security's maturity. The liquidity premium (LP) on all Tahoe Hydroponics's bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP):...
4. Calculating interest rates Aa Aa E The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next three years and 3% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t - 1)%, where t is the security's maturity. The liquidity premium (LP) on all Pellegrini Southern Inc.'s bonds is 1.05%. The following table shows the current relationship between bond ratings and...