Dynamic Debt Structure, Market Value of Firm, and Recovery Rate
54 Pages Posted: 8 Mar 2010 Last revised: 17 Mar 2010
Date Written: March 7, 2010
This paper examines the determinants of the outcomes of the default recovery process. We find that a new variable that incorporates not only the percentage of debt more senior to the debt instrument, but also debt at the same rank, is the most important factor driving the recovery rate. It is responsible for more than half of the total variation in recovery rates that can be explained by a comprehensive list of recovery determinants in our study, outweighing the instrument and collateral types. This finding suggests that, instead of merely focusing on debt seniority and collateral types at issuance, investors, banks, and rating agencies need to incorporate firms’ dynamic debt structure to obtain accurate recovery rate estimation. Furthermore, we find that firm’s trailing 1-year stock return is the second most important determinants of recovery rates, accounting for about one-third of the variation in recovery rates that can be explained. After controlling for the firm-level variables, the industry-level and macro-level variables play relatively minor roles in explaining recovery. However, if trailing 1-year stock return is not available (for example, for private firms), industry conditions would then be crucial in explaining recovery rates.
Keywords: recovery rate, loss given default (LGD), industry conditions, economic conditions, expected loss, credit risk, debt structure
JEL Classification: G32, G33, G38
Suggested Citation: Suggested Citation