Recovery Rate
It depends on the market value of the collateral, the risk level, the relevant industrial entities, and the macroeconomic conditions
What Is Recovery Rate?
The recovery rate (RR) depends on the market value of the collateral, the risk level, the relevant industrial entities, and the macroeconomic conditions. The average delinquency recovery rate in the UK financial industry is approximately between 20% and 60%.
These rates are constantly changing between industries, banks, and countries. Therefore, an additional risk discount is required to compensate for the possibility of such an occurrence. That is, the delinquency exceeds the historical rate.
For example, when a country's economy is on a downward trend, the RR delinquency rate may rise.
Not only that but when a financial institution prices its atypical loan business, it cannot use an averaging process to estimate expected losses accurately but must add a safety balance.
Another way to deal with unanticipated losses is to use value-at-risk (VAR) analysis to determine the extent of possible losses.
When the economy is doing well, including a risk discount in the price of financial products allows financial institutions to make higher profits. Conversely, the RR profit is lower when the economy is recessionary.
Such significant changes in profits can harm the share price of financial institutions. Therefore, financial institutions must establish customary terms for loan losses.
The RR adds a risk discount to the loan interest rate to make their profits more consistent. However, this approach requires that the accrual effect of the clause be determined even when no future losses occur.
The RR is defined in NASDAQ's Financial Dictionary as the amount recovered through foreclosure or bankruptcy proceedings, etc., in the event of default. It is expressed as a percentage of face value.
A proper understanding of the RR should take into account the following points. First, the RR is directly related to the event of default. Different definitions of default by institutions will directly lead to variances in the statistics of recovery rates.
Second, these rates are usually expressed as a percentage, with the numerator being the amount recovered and the denominator being the face value of the debt instrument.
However, in kind, many institutions use the sum of the face value of the debt instrument and the related interest as the denominator. Third, the default RR is closely related to the default loss rate. The higher the default loss rate, the lower the rate.
Recovery Rate Calculation
There are two main methods of standard RR calculation. The first is calculating the RR in terms of the final recovery amount. This method is usually easier to understand.
For example, if a bond has a total face value of $100 million and the investor ultimately recovers only $80 million after default, the RR is 80%. In addition, there is a more common method of measurement in practice.
That is, the market price of the debt instrument within several trading days after default are metric to make the estimate.
For example, the RR of a particular bond issued by a company is measured as the average value of the trading price of a unit denomination of the bond during the default date and the following 30 trading days.
The calculation reflects the average level that bond investors can expect to recover if the bond has a default event and continues to trade for the following 30 trading days.
This approach is used because many bond investors have portfolio management rules or investment objectives that would require them to liquidate their bond holdings within a short period after a bond default.
Even for investors who want the defaulted bonds to be mailed straight through to the end, the short-term post-default bond market price is a more reasonable projection of the ultimate expected level of bond recovery.
Factors Affecting the Rate of Corporate Bond Defaults
Research shows that the main factors influencing the default RR of corporate bonds can be grouped into four categories.
One is macroeconomics, including the economy's general state and the market's overall default rate. The second is the industry environment, including the default rate of the industry.
The third is the characteristics of the bond issuer, including company size, default boundary, and equity value as a percentage of total assets.
Fourth is the bond's characteristics, including the bond's maturity, the coupon rate, the possibility of entering into credit default swap contracts, investment restrictions, and financing restrictions.
In short, the four characteristics are the macroeconomic environment, the industry environment, the bond issuers, and the bonds' operations.
Economic Environment
First, the influence of the macroeconomic environment on the bond RR is comprehensive. Generally speaking, poorer economic conditions tend to trigger lower bond recovery rates because systemic risk affects the overall recovery level of bonds.
Conversely, optimistic economic dynamics tend to increase the RR of bonds. Moreover, Jankowitsch et al. (2014) show that corporate bonds have low recovery rates in the presence of high market default rates and low short-term interest rates.
Specifically, for each percentage point increase in the market default rate, the RR of corporate bonds will decrease by 3.3 percentage points.
This finding is similar to that of Altman et al. (2002), who showed a negative correlation between the overall default rate and the overall RR.
Choose a bond with a guarantee or other credit enhancement. Set up restrictive clauses in the bond agreement to protect investors. Dynamically track significant operational and financial changes of the bond issuer.
Reasonably arrange the industry distribution structure of bond investments. Pay attention to credit ratings and adjust asset allocation promptly following the changes in ratings. All of these methods can help risk-averse investors protect their bond recovery rate.
Industry Environment
Corporate bond default recovery rates are influenced by the macroeconomic environment and the specific industry in which the issuer operates.
The risk characteristics of the industry, development cycle, competition, and policy regulation all have indirect or direct effects on the recoverability of bonds.
For example, in the study by Jankowitsch et al. (2014), the sample firms are divided into two categories, financial and non-financial firms, to study the RR characteristics. Their study found that these rates differed more significantly across industries.
For example, among non-financial companies, utility and energy companies had significantly higher recovery rates than the retail sector. Among financial companies, the RR is higher in the credit financing industry than in the financial services industry.
In addition, Jankowitsch et al. found that for every one percentage point increase in the industry default rate, the corresponding industry RR would decrease by 0.7 percentage points.
Characteristics of the Bond Issuer
The RR of corporate bonds is closely related to the characteristics of the bond issuer. So, which factors have the most significant impact on the RR?
According to Jankowitsch et al. (2014), the ratio of equity value to total assets and the default boundary is the key influencing factors. Among them, the default boundary equals the sum of short-term debt and 50% of long-term debt to total assets.
The study shows that the higher the ratio of equity value to total assets, the lower the default boundary. Then the higher the bond RR.
In particular, for every one percentage point increase in the ratio of equity value to total assets or every one percentage point decrease in the default boundary, the bond recovery rate increases by 1.3 percentage points and 2.2 percentage points, respectively.
In addition to the above elements, indicators such as the size of the issuer's company and the proportion of receivables to total assets will also impact the recovery level of corporate bonds.
Bond Characteristics
The bond characteristics referred to here include the maturity of the bond issue, the coupon rate, the credit rating, the possibility of entering into credit default swap contracts, and the restrictive terms associated with the bond.
Jankowitsch et al. (2014) show that longer bond maturities correspond to lower recovery rates. The RR decreases by 0.6% for every one-year bond maturity extension. The coupon rate has a weak positive correlation with the bond RR. Also, bond credit rating is a crucial factor.
The bond grade in the year before the default conveys information about the bond RR to a certain extent. Research shows that one small credit grade difference will result in a 1.1% RR difference.
In addition, the ability to enter into credit default swap contracts significantly impacts recovery rates. For instance, the study shows that the RR of bonds that can enter into credit default swaps is 6.2% higher than that of bonds that cannot enter into credit default swaps.
In addition to the above factors, the bond contracts have some restrictive clauses. For example, investment restriction clauses and financing restriction policies are effective tools for bond purchasers and holders to enhance recovery rates.
Indicators of default recovery rates: recovery ratings
Since the default RR is so critical for bond investors, it is directly related to the safety of investment funds. Thus, a reasonable forecast of RR becomes especially important.
As early as December 2003, Standard & Poor's Ratings Services began issuing recovery ratings. In addition, they provide creditors with a reference for estimating the rate of debt instruments after default.
At that time, the ratings were mainly for secured bank loans within the United States. Later, S&P gradually expanded the target of recovery ratings to all types of debt instruments without security measures.
S&P has also expanded its business to other regions outside the US, including Europe, Asia, Latin America, and Africa.
S&P's recovery ratings are used to assess the ultimate expectation of the level of recovery of debt principal and related interest on a particular debt instrument under a simulated default scenario.
Moreover, S&P's recovery rating methodology estimates the percentage that a bondholder can expect to recover following a formal bankruptcy proceeding or informal out-of-court restructuring.
Recovery assets may take a variety of forms. These include cash, debt, or equity securities issued by the reorganized entity or a combination of these asset types.
In addition to S&P, Fitch Ratings has established its unique recovery rating system. Under Fitch's current rating criteria system, the targets of recovery ratings are divided into three main categories.
These include general non-financial, public utility, and equity-based real estate investment trusts. Two different rating methods are used for debt recovery ratings or general non-financial enterprises.
The bespoke analysis is applied to the RR analysis of low speculative grade issuers' debt. The term low speculative grade here refers to issuers with an issuer default rating (IDR) of B+ or below.
The other type of analysis, aggregation analysis, applies to investment grade or high investment grade issuer debt.
In addition, Fitch Ratings also considers the potential bankruptcy restructuring costs of the debtor in the event of default.
There are other priority claims and concessions made by senior bondholders to lower-rated creditors to reach an agreement or restructure proposal II in its analysis.
In addition, Moody's Investors Service has extensively researched default recovery. Consequently, an analytical framework has been developed based on loss-given default (LGD). Its analytical framework applies to single loans, bonds, preferred stocks, etc.
The main focus is on the LGD model, which emphasizes the debt structure of the debtor at the time of default and the probability distribution of the RR. This method obtains the LGD level of the rated subject.
The LGD rating of Moody's reflects the debt instrument's expected loss-given default (LGD) rate after default, expressed in percentages.
Recovery Rate FAQs
Estimated recovery value (ERV) is the expected value of assets that can be recovered when the company faces liquidation or closure, calculated by multiplying the rate by the asset’s book value.
RR refers to the amount recovered by the lender when a borrower defaults on loan repayments. For securities, the rate can represent the value of the security in the event of default or bankruptcy.
Debt collection is when a loan is overdue and not paid, and the creditor hires a third party to perform collection services. Debt collection is crucial because it is directly related to your credit score.
Researched and authored by Zezhao Fang | LinkedIn
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