Recovery Rate

What Is Recovery Rate?

The recovery rate 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 recovery rate 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; it 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 recovery rate 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. 

Understanding Recovery Rate

The recovery rate 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.

NASDAQ's Financial Dictionary defines the recovery rate 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 recovery rate should consider the following points.

1. It 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. 
2. 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.
3. The default recovery rate 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 recovery rate calculation. The first is calculating the recovery rate 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 recovery rate 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 is the metric to make the estimate. 

For example, the recovery rate 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 recovery rate of corporate bonds can be grouped into four categories. 

1. Macroeconomics, including the economy's general state and the market's overall default rate.
2. The industry environment, including the default rate of the industry. 
3. The characteristics of the bond issuer include company size, default boundary, and equity value as a percentage of total assets. 
4. The bond's characteristics include its maturity, 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.

Macroeconomic Environment

The influence of the macroeconomic environment on the bond recovery rate 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 recovery rate 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 recovery rate 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 recovery rate.

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 industry's risk characteristics, development cycle, competition, and policy regulation all have indirect or direct effects on bond recoverability. 

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 recovery rate 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 recovery rate 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 recovery rate would decrease by 0.7 percentage points.

Characteristics of the Bond Issuer

The recovery rate of corporate bonds is closely related to the characteristics of the bond issuer. So, which factors have the most significant impact on the recovery rate? 

According to Jankowitsch et al. (2014), the ratio of equity value to total assets and the default boundary are the key influencing factors. 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 recovery rate. 

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 recovery rate decreases by 0.6% for every one-year bond maturity extension. The coupon rate has a weak positive correlation with the bond recovery rate. Also, bond credit rating is a crucial factor. 

The bond grade in the year before the default conveys information about the bond recovery rate to a certain extent. Research shows that one small credit grade difference will result in a 1.1% recovery rate difference. 

In addition, the ability to enter into credit default swap contracts significantly impacts recovery rates. For instance, the study shows that the recovery rate of bonds that can enter into credit default swaps is 6.2% higher than that of bonds that cannot. 

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

Recovery rates (RR) are crucial for bond investors because they directly impact the safety of investment funds. Accurate forecasts of recovery rates are essential for assessing the potential losses that investors might face in the event of a default.

Various rating agencies, such as Standard & Poor's (S&P), Fitch Ratings, and Moody's Investors Service, have developed methodologies to predict these recovery rates.

Standard & Poor's Recovery Ratings

S&P began issuing recovery ratings in December 2003, initially focusing on secured bank loans within the United States. Over time, S&P expanded its recovery ratings to cover all types of debt instruments, including unsecured ones.

The scope of these ratings also extended beyond the U.S. to Europe, Asia, Latin America, and Africa.

Methodology:

1. S&P's recovery ratings assess the expected level of recovery for debt principal and related interest under a simulated default scenario.
2. The ratings estimate the percentage of recovery that bondholders can expect following a formal bankruptcy proceeding or an informal out-of-court restructuring.
3. Recovery assets may include cash, debt, or equity securities from the reorganized entity or a combination of these.

Fitch Ratings' Recovery Rating System

Fitch's recovery ratings are divided into three main categories: general non-financial, public utility, and equity-based real estate investment trusts.

Methodology:

Two different methods are used for assessing recovery rates:

1. Bespoke Analysis: Applied to low-speculative-grade issuers' debt (issuers with an Issuer Default Rating (IDR) of B+ or below).
2. Aggregation Analysis: Used for investment-grade or high-investment-grade issuer debt.

Fitch considers potential bankruptcy restructuring costs and the priority claims and concessions senior bondholders make to lower-rated creditors to reach agreements or restructure proposals.

Moody's Investors Service and Loss-Given Default (LGD)

Moody's has developed an analytical framework based on the concept of Loss-Given Default (LGD). The LGD model focuses on the debtor's debt structure at the time of default and the probability distribution of the recovery rate.

The LGD rating reflects the expected loss given default for various debt instruments, including single loans, bonds, and preferred stocks, expressed as a percentage.

Moody's framework emphasizes the expected loss-given default rate after default, helping to provide a clear picture of potential recovery percentages for bondholders.

Uses Of Recovery Rate

The recovery rate, which indicates the percentage of a debt's principal and accrued interest that investors can expect to recover in the event of a default, has numerous practical applications across various sectors.

Here are some key uses:

1. Credit Risk Management: Using recovery rates, financial organizations determine loan loss provisions and evaluate credit risk.
2. Investment Decision-Making: To balance risk and reward, investors consider recovery rates when choosing bonds and managing portfolios.
3. Pricing and Valuation: Accurately utilizing valuation algorithms and setting prices for debt instruments depend heavily on recovery rates.
4. Regulatory Compliance: Banks conduct stress tests and employ recovery rates to meet capital needs in accordance with regulatory frameworks.
5. Credit Ratings: In order to provide precise credit ratings, rating firms integrate recovery rates into their algorithms.
6. Debt Restructuring: During restructuring and bankruptcy processes, creditors bargain conditions using recovery rates.
7. Financial Modelling: To forecast possible outcomes, analysts employ recovery rates in scenario analyses and loss-given default models.

Advantages of Recovery Rate

The recovery rate is a critical metric in the assessment of credit risk and investment safety. Here are several benefits of understanding and utilizing recovery rates:

1. Better Risk Assessment: By highlighting possible losses in default circumstances, recovery rates make it possible to accurately assess credit risk.
2. Making Well-Informed Investment Decisions: To maximize risk-adjusted returns, investors can select bonds with greater recovery rates.
3. Precise Pricing and Appraisal: Recovery rates aid in the proper pricing of debt instruments by indicating their actual risk and prospective value upon recovery.
4. Regulatory Compliance: To make sure they have enough reserves, financial institutions use recovery rates to determine their capital requirements.
5. Efficient Creditor Negotiations: In order to optimise recoveries during debt restructuring or bankruptcy procedures, recovery rates offer leverage.

Disadvantages Of Recovery Rate

Several disadvantages of the recovery rate can be seen as under:

1. Uncertainty and Variability: Recovery rates might differ greatly based on the state of the economy and the particulars of the default.
2. Complicated Calculation: Recovery rate estimation necessitates intricate modeling and assumptions, both increasing the risk of error.
3. Market Sentiment Impact: If expectations are not fulfilled during defaults, an over-reliance on recovery rates could cause market instability.
4. Data Restrictions: Complete historical data is necessary for accurate recovery rate estimation, but it's not always available.
5. Potential Misinterpretation: Without knowing the underlying assumptions and constraints, investors may misinterpret recovery rates.

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