Default

Exam items almost always force you to separate default probability from default loss: a question gives recovery data and asks for loss given default = 1 − recovery rate, or hands you PD, LGD, and EAD and wants expected loss — the trap is forgetting that higher seniority lowers LGD, not the probability of default (the curriculum treats PD as the same for an issuer and its issues, so seniority only shifts recovery, which is why ratings get “notched”). A second classic pattern asks which event constitutes default: missing a coupon or principal payment qualifies, and so can breaching a covenant — but a covenant breach is typically a technical default that can be cured or waived before it becomes a payment default.

Don’t conflate the pieces with their neighbors. Spread is the market price of this risk (compensation for expected loss plus a risk premium), so widening spreads signal rising default expectations — but spread also embeds liquidity and tax components, not just credit. The indenture defines what counts as default and the remedies; weaker (covenant-lite) protections raise loss severity, not default frequency. Memory hook: PD is whether, LGD is how bad — seniority only moves the second.