What Is Loss Given Default (LGD)?
Loss given default answers a specific question: if this borrower defaults, what fraction of the money at stake will actually be lost? It is expressed as a percentage of the exposure at default and is measured net of whatever the lender recovers from collateral or a restructuring, after subtracting the costs of the workout itself. An unsecured bond that recovers 40 cents on the dollar carries a 60% LGD.
LGD varies enormously across the capital structure. A first-lien loan backed by valuable, saleable collateral might lose only 20% to 30% of its value in a default, while a subordinated bond behind layers of senior claims can lose most of its face amount. That spread is precisely why lenders negotiate for security interests and structural seniority in the first place.
How LGD Is Estimated and Used
LGD is one of the multipliers in the standard credit-loss equation: expected loss = PD × LGD × EAD, where PD is the probability of default and EAD is the exposure at default. Under the Basel framework's foundation approach, banks apply prescribed values — 45% for senior unsecured claims on corporates and 75% for subordinated exposures — while the advanced approach lets qualifying banks substitute their own internally modeled estimates.
Estimating LGD well requires looking beyond averages. Regulators require banks to use downturn LGD figures, because recoveries deteriorate in recessions just as defaults spike, with collateral being liquidated into falling markets. Practitioners also model LGD at the facility level, since the same borrower can have a low-LGD secured revolver and a high-LGD unsecured bond outstanding simultaneously.
Why LGD Matters
LGD explains why two loans to the same company can carry very different interest rates. Since the borrower's default probability is identical for both, the pricing gap comes almost entirely from expected severity, which is why secured lenders accept thinner spreads than unsecured bondholders. Much of credit structuring — collateral packages, guarantees, covenants, and intercreditor terms — exists specifically to compress LGD.
The concept also shapes ratings and analysis. Agencies notch individual bond ratings above or below the issuer's rating based on expected loss severity, and credit investors compare market prices against their own LGD estimates to find mispriced risk. Candidates interviewing for credit funds or restructuring groups should be able to walk through the expected-loss formula and explain how collateral and seniority move each component.
