Loss-Adjusted Spread Test
Subtract expected default losses before judging a credit spread
- Difficulty
- Moderate
- Time to result
- ~days to results
- Steps
- 6
- Confidence
- 96%
The Loss-Adjusted Spread Test evaluates credit compensation after accounting for the principal likely to be lost through defaults. Start with the contractual spread, select a consistent investment horizon, and estimate both cumulative default probability and loss severity after recoveries. Subtract that expected loss from the offered spread, then stress the assumptions for adverse conditions. The framework also corrects a recurring behavioral error: investors may underestimate losses during bad markets because spreads look enticing, yet overestimate losses during strong markets because low spreads feel inadequate. Comparing opportunities on a loss-adjusted basis reveals whether a lower spread is justified by unusually low defaults or whether a high spread merely compensates for substantial expected impairment.
Origin
Jonathan Lavine explained the calculation while discussing private-credit valuations and unusually low default rates on Masters in Business.
Core principles
- 01Quoted spread is not expected return
- 02Expected default losses vary with the cycle
- 03Market sentiment can distort loss estimates
- 04Spread comparisons require a consistent time horizon
How to run it
- 1
Capture the offered spread
Record the annual spread over the relevant benchmark and any fees that affect expected return.
Pro tip Normalize instruments to the same benchmark and horizon.
Watch out Do not compare headline yields that embed different base rates.
- 2
Set the horizon
Choose the next two or three years, or another period appropriate to the instrument's maturity and call structure.
Pro tip Use the same horizon across competing opportunities.
Watch out A short horizon can omit a known maturity or refinancing risk.
- 3
Estimate defaults
Estimate cumulative default probability using company fundamentals, industry conditions, and cycle-aware evidence.
Pro tip Create base, upside, and downside estimates.
Watch out Recent default rates may not represent the coming period.
- 4
Estimate severity
Calculate the likely percentage loss after collateral recoveries, restructuring costs, and time delays.
Pro tip Use capital-structure position and asset quality to inform recovery.
Watch out Historical average recoveries may be too optimistic for correlated downturns.
- 5
Calculate adjusted spread
Subtract expected default loss from the offered spread to estimate net credit compensation.
Pro tip Include fees and hedging costs consistently where material.
Watch out Expected values can conceal a wide distribution of outcomes.
- 6
Stress and compare
Recalculate under higher defaults and lower recoveries, then compare the result with other investments.
Pro tip Prefer opportunities that remain acceptable under plausible stress.
Watch out Do not select an investment solely because its base-case adjusted spread ranks first.
In the wild
A loan offers a below-average spread while current defaults are also well below average. The investor subtracts a modest expected loss rather than rejecting the loan solely because its headline spread is historically tight.
→ The investor evaluates compensation relative to actual credit conditions rather than a decontextualized historical average.
A cyclical borrower offers a 700-basis-point spread. After incorporating a high default probability and weak collateral recovery, the expected loss consumes most of the apparent premium. A more resilient borrower with a narrower spread produces the stronger loss-adjusted return.
→ The lender avoids a high-yielding instrument with poor expected compensation.
Common mistakes
Stopping at headline spread
The contractual spread ignores principal losses and therefore overstates expected credit compensation.
Using sentiment as a loss estimate
Fear can inflate expected losses in healthy markets, while optimism can suppress them near cyclical peaks.
Ignoring recovery severity
Default frequency alone cannot estimate losses because collateral and capital-structure position materially affect recovery.
Is it for you?
Best for
It is best for comparing loans, bonds, and private-credit opportunities with different default risks.
Not ideal for
It is not ideal as a standalone measure for distressed securities with highly path-dependent recoveries.
From the transcript
“when you make a loan, you look at the spread you're getting and then you always net out what you presume you're gonna lose um…”
“And I think not enough people look at loss adjusted spread that in bad markets, people probably underestimate what the losses would be, and in…”
From the episode
Jonathan S. Lavine on Private Equity Investing (Podcast)
Jonathan S. Lavine