Default risk is the probability that a borrower or a debt issuer fails to make a required principal or interest payment when it comes due. The Municipal Securities Rulemaking Board states the investor side plainly: credit or default risk is the risk that a bond issuer or obligor will be unable to make interest or principal payments as they become due (MSRB, Investment Risks). It attaches to a specific obligor or obligation and looks forward, so it is a probability rather than a loss already recorded.
What Counts as Default
Where bank capital is at stake the word carries a defined test. Under the OCC’s capital rules a wholesale obligor is in default if the bank determines the obligor is unlikely to pay its credit obligations in full without recourse to actions such as realizing collateral, or if the obligor is past due more than 90 days on any material credit obligation (12 CFR 3.101).
Retail exposures run on bright lines rather than that judgment: 180 days past due for a residential mortgage or revolving exposure, 120 days for other retail exposures, or a full or partial charge-off, write-down of principal, or material negative fair value adjustment of principal on the exposure for credit-related reasons (12 CFR 3.101). Because default is an event with a date, the risk of it is a probability over a stated horizon, and a late payment is not automatically a default.
How Default Risk Is Measured
Three quantities carry the measurement, and the same rules define each one. Probability of default (PD) is the lender’s empirically based best estimate of the long-run average one-year default rate for the rating grade assigned to the obligor. Loss given default (LGD) is the lender’s empirically based best estimate of the economic loss it would expect to incur, per dollar of exposure at default, if the obligor defaulted within a one-year horizon. Exposure at default (EAD) is the amount expected to be owed at that moment, which for an on-balance-sheet exposure is the carrying value including net accrued but unpaid interest and fees (12 CFR 3.101).
Expected credit loss, as the capital rules define it, is where the three meet. For a non-defaulted obligor it is the product of the probability of default times the loss given default times the exposure at default, unless the exposure is carried at fair value with gains and losses flowing through earnings or is classified as held-for-sale at the lower of cost or fair value with losses flowing through earnings, in which case the rule sets it at zero (12 CFR 3.2).
A Worked Example
Say a lender holds a single exposure on the inputs below.
exposure at default (EAD) 500,000
probability of default (PD) 3.0%
loss given default (LGD) 40%
expected credit loss 0.030 x 0.40 x 500,000 = 6,000That figure is not a forecast that this one loan loses that amount, since a loan either defaults or it does not. It is an average across many exposures of the same shape, which is why the inputs are estimated on grades and segments.
What the Market Charges for It
A credit rating is an assessment of an entity’s ability to pay its financial obligations, and an obligor with a high rating is assessed to have a lower likelihood of default than one with a lower rating. On the scales that draw the line, investment grade and non-investment grade split between the BBB and BB categories (SEC, The ABCs of Credit Ratings). Price follows the rating: high-yield bonds have a lower credit rating, implying higher credit risk than investment-grade bonds, and therefore offer higher interest rates in return for the increased risk (SEC, Bonds).
The opposite pole already has a name here: the risk-free rate that the CAPM equation and arbitrage pricing theory both start from is the return on an asset treated as carrying no default risk.
Where a US Firm Meets Default Risk
On a client’s receivables, first. The forward-looking probability that a customer will not pay is the risk, and the accounting estimate of it is the allowance for credit losses, developed from information relating to past events, current conditions, and reasonable and supportable forecasts (FASB, Accounting Standards Update 2016-13, paragraph 326-20-30-7). That allowance is measured over the contractual term of the financial asset rather than the capital rules’ one-year horizon (FASB, Accounting Standards Update 2016-13, paragraph 326-20-30-6). The measurement, the entries and the worked example already live in allowance for doubtful accounts, bad debt expense, doubtful debt, the direct write-off method and net realizable value.
On the borrowing side it is what a lender’s paperwork exists to catch early. The promises whose breach becomes an event of default are in covenants, and the cushion behind them is measured by the debt service coverage ratio and the times interest earned ratio, and read against the whole balance sheet in solvency. Where the debt is a security rather than a loan, the recovery half is contractual, set by the indenture and by whether the lender’s claim is recourse or a non-recourse loan.
Default Risk, Credit Risk, and Bad Debt
Credit risk is the wider label, and investor education often runs the two names together: the MSRB files them under one heading, Credit/Default Risk (MSRB, Investment Risks). They come apart at the point of measurement. Default is a defined event and its probability is one of three inputs to an expected loss, so default risk names the probability leg while credit risk names the whole exposure to a borrower’s condition, including what a rating change does to a holder who is still being paid on time. Rating changes can happen at any time, without warning, and at any rating level (SEC, The ABCs of Credit Ratings).
Bad debt sits on the other side of the clock. It is the realized outcome, already recognized in the ledger, while default risk is the probability standing in front of it. One gets written off and the other gets estimated.
Default risk is also not a synonym for unsystematic risk, which is the portion of a security’s risk that diversification can remove, because diversification spreads default risk across a book without removing the expected loss inside it.
Common Questions
No single ratio carries that name. Lenders quantify the risk with the three inputs above and screen for it with coverage measures read against the terms of the specific credit, not against a universal threshold. A rating is the closest thing to a one-line answer, and it carries its own caution: a credit rating is not a guarantee that a financial obligation will be repaid, and even debt rated AAA can default (SEC, The ABCs of Credit Ratings).
In ratings language it means sitting below the investment-grade line, so a rating lower than BBB-minus is non-investment grade on the scales that draw that distinction (SEC, The ABCs of Credit Ratings). In lending language it means a high estimated probability of default over the horizon being measured, and it usually shows up in the price of the credit rather than in an outright refusal.
Accountably places trained offshore accountants inside US CPA and EA firms, and a firm can put a block of its own allowance and covenant schedule work through a trial task before anything client facing depends on it.
