The Risk in Borrowing Default Risk and the Cost of Debt

When an investor lends to an individual or a firm, there is the possibility that the borrower may default on interest and principal payments on the borrowing. This possibility of default is called the default risk. Generally speaking, borrowers with higher default risk should pay higher interest rates on their borrowing than those with lower default risk. This section examines the measurement of default risk, and the relationship of default risk to interest rates on borrowing.

In contrast to the general risk and return models for equity, which evaluate the effects of market risk on expected returns, models of default risk measure the consequences of firm-specific default risk on promised returns. While diversification can be used to explain why firm-specific risk will not be priced into expected returns for equities, the same rationale cannot be applied to securities that have limited upside potential and much greater downside potential from firm-specific events. To see what we mean by limited upside potential, consider investing in the bond issued by a company. The coupons are fixed at the time of the issue, and these coupons represent the promised cash flow on the bond. The best-case scenario for you as an investor is that you receive the promised cash flows; you are not entitled to more than these cash flows even if the company is wildly successful. All other scenarios contain only bad news, though in varying degrees, with the delivered cash flows being less than the promised cash flows.

Consequently, the expected return on a corporate bond is likely to reflect the firm-specific default risk of the firm issuing the bond.

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