Probability of default explained: How to assess credit risk and make smarter bond investment decisions

In the nation's rapidly evolving debt market, clarity on the understanding of the probability of default (PD) is critical for every investor aspiring to invest in bonds. Whether you are investing in government securities, corporate bonds, or high-yield debentures, PD can help you assess the true risk of a borrower.

What is the probability of default?

To put it simply, the probability of default represents the likelihood, expressed as a percentage, that a borrower will fail to meet their debt obligations. It basically measures credit risk and influences both interest rates and bond pricing.

• Low PD: This signifies that the borrower is financially strong. It implies lower risk and lower yield.
• High PD: This signifies that the borrower is riskier and demands a higher yield to compensate the investors for the same.

For example, companies such as DHFL (2019), IL&FS (2018) witnessed their PDs rise before defaults became public. This clearly establishes PD’s role as an early warning signal.

How is PD calculated?

Prominent banks, credit agencies, investors and financial institutions assess PD using financial and market data. The following factors are primarily taken into account:

1. Financial strength: Leverage ratios, profitability, financial statements, and consistency in cash flow are checked.
2. Credit history: This metric includes on-time repayments and any past defaults. It is given proper consideration.
3. Industry outlook: The ongoing macroeconomic conditions and sectoral performance.
4. Market signals: Bond yields and Credit Default Swap (CDS) spreads reflect real-time PD.

These are some of the factors that are given due consideration while calculating the probability of default in bonds. It is crucial to note that the list is not exhaustive and only indicative.

What is the role of PD in bond investing?

For retail investors in the country aspiring to invest in corporate or NBFC bonds, the probability of default helps in:

1. Comparing bond features, pros and cons beyond just coupon rates.
2. Acknowledging and identifying early signs of credit deterioration.
3. Helps in taking remedial steps to balance overall risk.
4. Balancing expected returns with the holistic risk of the portfolio.

Conclusion

In conclusion, the concept of probability of default in bonds is not just a statistic. It is a risk-measuring compass. Furthermore, as India’s bond market continues to evolve, understanding this concept can enable investors to make prudent, data-driven bond investment decisions rather than relying solely on credit ratings.

Disclaimer: Investments in bonds and other debt instruments are subject to market risks, including the risk of default or delay in payments. The information provided above is for educational purposes only and should not be considered as investment advice or a recommendation to buy or sell any security. Investors are advised to read all offer documents carefully and consult with their financial advisor before making any investment decisions.