In plain language — A rating is an ordered credit opinion, not a promise. Default is an event defined by contract or methodology; recovery is the value obtained after it; LGD is the economic share lost.
Credit risk asks whether and how an issuer will perform. Markets and models answer with different measures: ratings, probability of default (PD), exposure at default (EAD), recovery rate and loss given default (LGD). Each measure has its own horizon, definition and data source.
A rating is not a percentage
A rating places an issuer or instrument on an ordinal scale under the agency's or institution's methodology. Issuer and issue ratings can differ because of seniority, guarantees and structure. “Investment grade” and “speculative grade” are common categories, but methodology and observation date still matter.
Ratings can change as information changes and do not directly measure price, liquidity or certain loss. Two instruments in the same class may have different spreads, maturities and expected recoveries. A historical default frequency for a rating class is not automatically the point probability of one security.
Default, recovery and LGD
Default can include missed payment, bankruptcy, distressed restructuring or other conditions, depending on contract and framework. Event date, grace periods and legal process matter.
Recovery rate compares recovered value with a defined reference. LGD represents the economic share not recovered. In the simplest intuition:
LGD ≈ 1 − recovery rateBut post-default market price, discounted final recoveries, collateral value and legal costs are not the same measure. Timing and discount rates can make the simple subtraction inadequate. Seniority, guarantees, jurisdiction, capital structure and economic cycle affect outcomes; a sample average is not a guaranteed recovery for a new case.
Expected loss from PD, LGD and EAD: calculation and scenarios
A widely used prudential representation is:
Expected loss = PD × LGD × EADAll three components need consistent horizon, currency and definitions. EAD is exposure expected when default occurs, not always today's balance. PD may be point-in-time or through-the-cycle; LGD may incorporate downturn conditions and costs. These choices serve different purposes.
Expected loss is not maximum loss and does not describe the full distribution. Concentration, correlated defaults, rating migration, spreads, liquidity and tail risk need additional scenarios. Market price includes risk premia and other factors, so it need not equal a statistical expected loss.
A readable professional workflow
Identify the legal entity and exact issue. Read rank, covenant, collateral, cross-default and option terms. Separate observed facts—statements, payments and prices—from external opinions and model output. Every estimate keeps its date, horizon, scenario and version.
For a portfolio, aggregate with look-through to issuers, guarantors, sectors and countries. Monitor migration and watchlists without presenting any threshold as universal. A downgrade can affect price, eligibility or collateral; the effect depends on contracts and participants.
Common error — Reading an “A” rating as no risk, or applying `1 − recovery` without defining base, timing and costs. Labels and formulas work only with traceable definitions.
Questions this page answers
Does the rating refer to issuer or issue? What counts as default? Is recovery a market price or final cash value? Do PD and LGD share a horizon? Does EAD include future drawings? Which concentrations remain outside expected loss?
Sources
- Investor.gov — Bonds or Fixed Income Products
- FINRA — Bonds
- Basel Committee — Basel III: Finalising post-crisis reforms