Conservatism, Covenants, and Recovery Rates
42 Pages Posted: 7 Jan 2013
Date Written: January 3, 2013
Abstract
We hypothesize and provide evidence that accounting conservatism and complementary accounting-based debt covenants increase expected recovery rates by preserving the firm’s fungible economic assets at levels sufficient to support recovery by debtholders. We employ Das & Hanouna’s (2009) approach to jointly estimate implied default and recovery rates from CDS spreads, implied stock return volatilities, and stock prices. Controlling for known determinants of realized recovery rates documented in the prior literature, we predict and find that implied recovery rates increase with the combination of conservatism and covenants, and that these results are stronger when conservatism is conditional rather than unconditional, for capital rather than performance covenants, for bonds rather than loans, for riskier firms, and when periodic accounting performance measures have less explanatory power for credit risk.
Keywords: Conservatism, Debt Contracting, Covenants, Recovery Rate, Default Rate, Loss Given Default, Credit Default Swap
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