Loss Given DefaultLGD
Loss given default is the share of an exposure that is lost if a borrower defaults. It is one minus the recovery rate: if lenders recover 40 cents on the dollar, the loss given default is 60%.
A default does not always mean losing everything. Creditors usually recover part of what they are owed, from assets, restructuring or bankruptcy proceedings. Loss given default is the part that is not recovered. Together with the probability of default and the size of the exposure, it determines the expected loss on a loan or bond. This entry explains the concept, what drives recoveries, and how it is used.
- Category
- Bonds and Interest Rates
- Reading time
- 4 min
- Also called
- Recovery rate, Severity of loss, Recovery
- Updated
Loss given default in plain words
A default is a failure to pay principal or interest when due.1 After a default, lenders recover some fraction of what they are owed — the recovery rate. Loss given default is the rest: LGD = 1 − recovery rate.
Lower-rated bonds have a higher risk of default and therefore pay higher yields.2 But how much investors lose when defaults happen depends on recovery, which varies with the type of debt and the company’s assets. See Default Risk.
How to use loss given default, step by step
Estimate the recovery rate
From the debt’s seniority, collateral and history.
LGD
1 − recovery rate.
Estimate the probability of default
Ratings and spreads help. See Credit Spread.
Know the exposure
How much is owed at default. See Exposure at Default.
Expected loss
Probability of default × LGD × exposure.
Compare with the yield
Is the extra yield enough to cover expected losses?
Worked examples
Example 1 — The basic calculation
DefaultAn investor holds $50,000 of bonds. The issuer defaults and holders recover 35%.
| Recovered | $17,500 |
| LGD | 65% → loss of $32,500 |
The recovery rate decides how painful a default is.
Example 2 — Expected loss
Expected lossA bond portfolio of $1,000,000 has an average default probability of 3% a year and LGD of 60%.
| Expected annual loss | 3% × 60% × $1,000,000 = $18,000 |
| As a share of the portfolio | 1.8% |
If the portfolio’s extra yield over safe bonds is below about 1.8%, it may not cover expected losses.
Example 3 — Seniority matters
SeniorityAfter the same default, secured lenders recover 70%, unsecured bondholders 30%.
| Secured LGD | 30% |
| Unsecured LGD | 70% |
Where your debt ranks in the queue strongly affects losses.
What tends to affect recoveries
| Aspect | Higher recovery | Lower recovery |
|---|---|---|
| Seniority | Senior, secured debt | Junior, unsecured debt |
| Collateral | Hard assets | Few tangible assets |
| Economic conditions | Defaults in good times | Defaults in recessions |
| Industry | Asset-heavy businesses | Businesses reliant on intangibles |
Where LGD is used
Credit investing
Judging whether yields cover expected losses.
Bank lending
Setting capital and loan pricing.
Portfolio risk
Estimating losses in downturns. See Recession.
Credit derivatives
Pricing default protection. See Credit Default Swap.
Advantages and disadvantages
Advantages
- Separates how often from how badly losses occur.
- Feeds directly into expected-loss calculations.
- Highlights the value of seniority and collateral.
Disadvantages
- Recoveries are uncertain until the process ends.
- Recovery rates fall when many defaults happen together.
- Estimates rely on history that may not repeat.
Going deeper
Read as far as you need. Each level builds on the one before it.
Default is not zero
Beginner
Bondholders often get something back after a default, but it can take a long time.
Recoveries move with the cycle
Intermediate
In recessions, defaults rise and recoveries tend to fall, so losses increase on both counts.
Expected vs. unexpected loss
Advanced
Expected loss is the average; capital must cover unexpected losses in bad years, when defaults and LGD rise together.
Common mistakes
Assuming zero recovery or full recovery
Use realistic estimates.
Ignoring seniority
Check where the bond ranks.
Using calm-period recovery rates
Stress periods recover less.
Forgetting time
Recoveries can take years.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- LGD is the share lost after a default: 1 − recovery rate.
- Expected loss = probability of default × LGD × exposure.
- Seniority and collateral drive recoveries.
- Recoveries tend to fall in recessions.
- Compare expected losses with the extra yield earned.
Frequently asked questions
What is a typical recovery rate?
Is LGD the same as recovery rate?
Why does LGD matter for high-yield investors?
Further learning
- Default Risk
How likely defaults are.
- Credit Spread
What investors are paid for credit risk.
- Recession
When losses rise.
- Fallen Angels and Rising Stars
Rating moves before defaults.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Investor.gov (SEC). Default (glossary) (opens in a new tab) Checked .
- Investor.gov (SEC). High-Yield Bond or Junk Bond (glossary) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.