Default Risk
Default risk is the probability that a borrower fails to meet its debt obligations under agreed terms.
Allocator relevance: A core driver of credit underwriting decisions, portfolio risk limits, and expected loss modeling.
Expanded Definition
Default risk reflects both ability and willingness to pay, influenced by cash flows, leverage, refinancing needs, covenant tightness, and macro conditions. In private credit, default risk is shaped heavily by structure: seniority, collateral, covenants, and lender control rights.
Allocators evaluate default risk as part of underwriting standards and stress testing, not just through yield spreads.
How It Works in Practice
Underwriters assess borrower fundamentals, downside scenarios, covenant packages, and capital stack position. They monitor early warning signals: covenant headroom, liquidity runway, margin compression, and refinancing timelines.
Decision Authority and Governance
Governance frameworks define allowable risk levels by strategy (senior secured vs unitranche), concentration limits, and required protections. Weak governance often shows up as spread-chasing in late-cycle markets.
Common Misconceptions
- Higher yield fully compensates for default risk.
- Seniority eliminates default risk.
- Default risk is static throughout a credit’s life.
Key Takeaways
- Structure and covenants materially affect default outcomes.
- Default risk rises in refinancing stress regimes.
- Stress testing is essential to avoid spread illusion.