The Role of CDS Spreads in Explaining Bond Recovery Rates

Abstract

Identifying the drivers of bond's recovery rates is an important and topical field of research. In spite of its obvious connections with recovery rates, credit default swap (CDS) spreads received little attention for this purpose. In this paper, we introduce two novel recovery rates determinants built from CDS market data. These dynamic indices capture the level and uncertainty information embedded in CDS spreads aggregated by industry sectors, thereby forming a new family of determinants sitting in between the idiosyncratic and systematic factors identified so far. Analyzing 613 defaulted U.S. corporate bond issues from 2006 to 2019 and using a beta regression model, we find the cross-sectional mean and approximate entropy of aggregated CDS spreads to be significant to explain the mean and dispersion parameters of the beta distribution underlying recovery rates. These findings offer valuable insights for improving credit risk assessment methodologies and identifying key risk drivers of recovery rates prior to running prediction models.

Keywords: Credit risk, Recovery rate, Credit default swap, Corporate bond, Uncertainty

JEL Classification: G21, G28, G32