4.1 Credit risk

Every lender makes money the same way: it charges interest, and it hopes to get its money back. Credit risk is the chance that it doesn't. It is the main risk in private credit, and the main reason loans pay more than cash in the bank.

You will hear three numbers again and again when people talk about credit risk: how often borrowers default, how much lenders get back when they do, and what that means for losses over a year. This lesson explains each one, shows how they fit together in a simple formula, and shows why a loan's pricing has to leave room for losses. The figures here are illustrative, not market data.

What default means

A default happens when a borrower fails to meet its obligations under the loan. The obvious case is a payment default: the company misses an interest payment or can't repay the loan when it is due.

But default can be defined more broadly. Depending on who is counting, it may also include:

• Covenant breaches. The borrower breaks a promise in the credit agreement, such as keeping its debt below a set multiple of earnings (see lesson 3.4).
• Distressed exchanges or amendments. The lender agrees to change the terms because the borrower is struggling, for example by extending the maturity, cutting the cash interest, or switching some interest to payment-in-kind (PIK).
• Bankruptcy filing. The borrower enters a formal insolvency process.

This matters because reported default rates depend on the definition. A manager that counts only missed payments will usually show a lower default rate than one that also counts covenant breaches and distressed amendments. Many problem loans are fixed quietly through an amendment before a payment is ever missed. When you compare default rates across managers, funds or research reports, always check what counts as a default.

Probability of default and the default rate

The probability of default (PD) is the chance that a borrower defaults over a given period, usually one year. Looking back at a portfolio, the default rate is the share of loans (by number or by value) that actually defaulted in that period.

A few points to keep in mind:

• PD varies by borrower. A company with steady revenue, low debt and strong cash flow is less likely to default than a highly indebted company in a cyclical industry.
• Defaults cluster in recessions. When the economy slows, many companies see earnings fall at the same time. Defaults that were rare in good years can rise sharply together. This is why a fund's loss history from a benign period can understate the risk.
• Averages hide the timing. A "long-run average" default rate blends good years and bad years. In practice, losses tend to arrive in bursts.

Recovery rate and loss given default

Default does not mean the lender loses everything. After a default, the lender usually gets some of its money back, through a restructuring, a sale of the company or its assets, or by taking ownership of the business.

The recovery rate is the share of the amount owed that the lender eventually gets back. Loss given default (LGD) is the share it loses:

LGD = 1 − recovery rate

So if a lender recovers 70 cents for every dollar owed, the recovery rate is 70% and the LGD is 30%.

Why seniority and security matter

Recovery depends heavily on where the loan sits in the capital structure (lesson 3.1). When a company fails, its remaining value is shared out in order of priority. Senior secured lenders are paid first, and they have a claim on specific assets (the collateral) such as the company's shares, receivables, equipment or intellectual property. Junior and unsecured creditors are paid only from what is left.

That is why senior secured loans have historically recovered more than unsecured debt. The exact gap varies by period, industry and study, but the direction is consistent. It is also why most direct lending funds focus on first lien and unitranche loans.

Recovery also depends on:

• How much debt ranks alongside or beneath the loan. The more debt that shares the same claim, the less each lender gets back. Junior debt and equity beneath the loan act as a cushion that absorbs losses first.
• The type of business. Companies with hard assets or valuable contracts can be easier to sell or restructure than businesses whose value is mostly in people.
• How quickly the lender acts. Covenants give lenders an early seat at the table (lesson 3.4). Acting early can protect value.

Expected loss: putting it together

The expected loss on a loan combines both ideas: how likely a default is, and how much is lost if it happens. For a portfolio over one year, a useful approximation is:

Annual loss rate ≈ default rate × (1 − recovery rate)

or, equivalently, default rate × LGD.

Here is an illustrative example for a portfolio of senior secured loans:

Input	Illustrative value
Annual default rate	2%
Recovery rate	70%
Loss given default (1 − 70%)	30%
Annual loss rate (2% × 30%)	0.6%

In words: if 2 loans in every 100 default each year, and the lender gets back 70% of what it is owed on those loans, the portfolio loses about 0.6% of its value a year to credit losses.

Notice how much the recovery rate matters. Keep the 2% default rate but assume only a 40% recovery, and the loss rate doubles:

Default rate	Recovery rate	LGD	Annual loss rate
2%	70%	30%	0.6%
2%	40%	60%	1.2%
4%	70%	30%	1.2%
4%	40%	60%	2.4%

Doubling the default rate and halving recoveries each double the loss. Doing both together, as can happen in a recession, quadruples it.

Why the spread must cover losses

A lender is paid for taking credit risk mainly through the spread: the margin it charges over the base rate (lesson 3.2). Some of that extra yield is compensation for expected losses. What is left over is the lender's actual return.

Continuing the illustration, suppose the loans earn a 10% all-in yield (base rate plus spread plus fees):

	Illustrative
All-in yield	10.0%
Less: expected annual loss rate	(0.6%)
Return after credit losses	≈ 9.4%

That 9.4% is before the fund's management fees, incentive fees and other costs, which reduce what investors actually receive. It is also an expected figure. In a good year losses may be close to zero; in a bad year they may be several times the average.

This simple subtraction explains a lot about private credit:

• Higher-yielding loans are not automatically better. A loan that pays 2% more but has a much higher chance of default, or a weaker recovery position, can end up returning less.
• Underwriting is about loss avoidance. Because the upside on a loan is capped at the agreed interest and fees, a lender's skill shows up mainly in avoiding defaults and maximizing recoveries when they happen.
• Averages can mislead. Pricing that looks generous against a long-run average loss can look thin if defaults cluster and recoveries fall at the same time.

Key terms

• Credit risk: the risk that a borrower does not pay interest or repay principal as agreed.
• Default: a failure to meet the loan's obligations. Depending on the definition, it can include missed payments, covenant breaches, distressed exchanges or amendments, and bankruptcy.
• Probability of default (PD): the likelihood that a borrower defaults over a given period, usually one year.
• Default rate: the share of loans in a portfolio that actually defaulted over a period.
• Recovery rate: the share of the amount owed that a lender gets back after a default.
• Loss given default (LGD): the share of the amount owed that is lost after a default; equal to 1 − recovery rate.
• Expected loss: the average loss a lender expects, combining the chance of default and the loss if it happens.
• Collateral: assets pledged to a lender that it can claim if the borrower defaults.

Key takeaways

• Credit losses depend on two things: how often borrowers default and how much lenders recover.
• Annual loss rate ≈ default rate × (1 − recovery rate). Illustratively, 2% × (1 − 70%) = 0.6%.
• Senior secured loans have historically recovered more than unsecured debt because they are paid first and hold collateral.
• Defaults cluster in recessions, and reported default rates vary with how "default" is defined.
• A loan's yield must cover expected losses and still leave a return, before fund fees and costs.