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Default Probability (PD)

Annualized probability of issuer default, implied from credit spread and assumed recovery rate.

The market-implied default probability is derived from credit spreads: PD ≈ Spread / (1 − Recovery Rate). This is the simplified CFA approach (risk-neutral PD). Example: 150 bp spread, 40% recovery → PD = 0.0150 / 0.60 = 2.5% annually. Key assumptions: constant hazard rate, spread = pure credit compensation (no liquidity premium). In practice, CDS-implied PDs are more accurate. Recovery rate varies by seniority: senior secured ~65%, senior unsecured ~40%, subordinated ~25%. Think of it as the break-even default rate that justifies the spread over Treasuries.

Formula
PD≈Spread1−RRPD \approx \frac{\text{Spread}}{1 - RR}