Taking a Look at Default Probability

Default probability is a measure of the likelihood that a borrower will be unable to repay a debt. Most people will come into contact with default probability when they take a personal loan, like a mortgage. The lender will consider multiple factors to determine if the borrower is likely to repay on time. If so, the interest rate will be low. If not, the interest rate may be high. This same principal can apply to investments on a large scale.

Credit Linked Notes

One instance of default probability affecting the securities market is with credit linked noted (CLNs). These investments are actually small pieces of business or consumer debts. When loans are issued, they are often sold on a secondary market to a special purpose company (SPC). This SPC then divvies up the loan, breaking it down into small pieces that can be purchased by investors. The investor receives a yield on the investment, and he or she will also receive a par value return if the loan is paid off on time. If not, the investor receives a discounted rate. The default probability on the original loan will affect the yield on the instrument. The more likely the default, the higher the interest rate on the CLN to attempt to make up for this potential loss. 

Bond Default Probability

A bond is simply an issuance of debt. A company can issue bonds when it needs to raise funds but prefers not to sell equity. Instead of selling pieces of the company through stocks, it instead promises to repay bonds to investors looking to turn a profit. To an investor, bonds are an attractive concept. They carry much lower risk than stocks in most situations. The lower the default probability on the bond, the lower the chance the bond will not pay off. Generally speaking, Treasury bonds have the lowest default probability of any investment on the market. They are backed by the full faith and credit of the US Treasury, and this institution cannot go bankrupt because it carries the ability to print money if necessary.

Using Default Probability to Consider Investment Opportunities

If you are a risk-averse investor, choosing investment opportunities with the lowest default probability is the best option for you. You will be guaranteed a very modest profit as long as the yield on the bond outpaces inflation. To assure this happens, you can even purchase inflation-protected bonds from the Treasury. However, this modest profit may not be enough for some investors. If you would prefer to assume a moderate level of risk in order to gain larger rewards, you may consider looking into investments with slightly higher default probabilities. Public works projects; bonds from major, A-rated institutions; and municipal bonds may be good ideas for your portfolio. On the final extreme, if you wish to take on a large amount of risk in hopes it will pay off, you may consider bonds with high default probability. CLNs, real estate investment trust bonds and other investment bonds are good options for you.

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