What Is Recovery Rate?
The recovery rate is the percentage of principal and accrued interest on defaulted debt that can be recovered by creditors. It is typically expressed as a percentage of the debt’s face value. Alternatively, it represents the value of a security when it emerges from default or bankruptcy.
Understanding the recovery rate is crucial for estimating potential losses in the event of a default, which is referred to as Loss Given Default (LGD). The formula used to calculate LGD is:
11 - Recovery Rate = Loss Given Default (LGD)
Therefore, if the recovery rate is 60%, then the LGD is 40%. On a $10 million debt instrument, the estimated loss arising from default would be $4 million.
Key Takeaways
- Recovery rate is the estimated percentage of a loan or an obligation that will still be repayable to creditors in the event of a default or bankruptcy.
- The recovery rate on senior debt generally carries a high value, while junior debt may have a significantly lower rate, even approaching zero.
- For instance, following the 2008 financial crisis, the average recovery rate for senior unsecured bonds dropped from 53.3% in 2007 to 33.8% in 2008.
Unlocking the Meanings Behind Recovery Rates
Various factors can impact recovery rates, including the type of debt instrument, corporate-specific issues, and macroeconomic conditions. Highly influential factors include the instrument’s type and seniority within the corporate capital structure. Typically, senior debt sees higher recovery rates than junior debt.
Factors Influencing Recovery Rates
- Corporate Issues: These include the company’s capital structure, amount of equity, and leverage. For instance, debt instruments issued by a less-leveraged company relative to its assets usually experience higher recovery rates.
- Macroeconomic Conditions: Relating to overall market trends, economic cycles, and liquidity. For example, non-recovery rate periods such as recessions often see plummeted recovery rates.
Impact of Recovery Rates on Lending
For lenders, understanding and calculating the recovery rate is paramount. It aids in setting future loan or credit terms. For example, if a recovery rate is lower than expected, then banks and lenders might opt to increase interest rates or shorten the repayment schedules to counterbalance added risks.
Example Calculation
To compute the recovery rate, determine the total money lent and the total received back within a specific timeline.
For instance, during one week, $15,000 in credit was extended, and $2,000 in payments were recovered:
$2,000 ÷ $15,000 = 13.33%
Thus, the recovery rate for the week is 13.33%.
Frequently Asked Questions About Recovery Rate
What does recovery rate mean?
The recovery rate is the percentage of defaulted debt that can be recuperated by creditors or lenders. It also pertains to the value of a security following its emergence from default or bankruptcy. Lenders and businesses utilize recovery rates to estimate the Estimated Recovery Value (ERV) of assets upon liquidation.
Why is knowing the recovery rate valuable?
Understanding recovery rates enables accurate risk evaluations and helps formulate terms, interest rates, and repayment durations for future credit transactions.
Are recovery rates the same across all debts?
No, recovery rates are not universal across all debt types. Senior debt generally benefits from higher recovery rates compared to junior debt. Factors influencing variations include the corporate capital structure, debt instrument type, level of corporate indebtedness, and broader macroeconomic conditions.
Related Terms: Loss Given Default, Capital Structure, Macro Economics, Senior Debt, Junior Debt.
References
- Nasdaq. “Recovery Rate”.
- Harbourfront Technologies. “How Bond Recovery Rate Is Calculated”.
- Bank for International Settlements. “An Option Theoretic Model for Ultimate Loss-Given-Default with Systematic Recovery Risk and Stochastic Returns on Defaulted Debt”, Page 1, Footnote 2.
- Federal Reserve Bank of Kansas City. “What Determines Creditor Recovery Rates?”, Pages 1–2.
- Moody’s Investor Service. “Determinants of Recovery Rates on Defaulted Bonds and Loans for North American Corporate Issuers: 1983–2003”, Page 1.
- Moody’s Investors Service. “Moody’s Ultimate Recovery Database”, Page 5.
- Moody’s Investors Service. “Corporate Default and Recovery Rates, 1920–2008”, Page 2.
