Lesson 3 of 7 · 12 min
What drives default risk and recovery
The probability of default is driven by profitability, coverage and leverage, while the loss given default depends mostly on where your claim ranks and what backs it.
In short
- Lower POD comes with higher profitability (e.g. EBIT margin), higher coverage (EBIT / interest expense) and lower leverage (e.g. debt / EBITDA, or a higher cash flow to net debt).
- Changes in these ratios over time can lead to rating upgrades or downgrades and to changing spreads.
- LGD depends mainly on the seniority and nature of the claim: secured debt ranks highest and has the lowest LGD.
- Pari passu and cross-default clauses mean a default on one obligation puts all the issuer's debt in default.
- IG unsecured investors (high LGD) worry most about a rise in POD; HY investors seek covenants and security to cut LGD.
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