What Is Recovery Rate?
Recovery rate is the extent to which principal and accrued interest on defaulted debt can be recovered, expressed as a percentage of face value. The recovery rate can also be defined as the value of a security when it emerges from default or bankruptcy.
The recovery rate enables an estimate to be made of the loss that would arise in the event of default. This is called loss given default (LGD) and is calculated by the following formula:
1 - Recovery Rate = Loss Given Default (LGD)
Thus, 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.
- Recovery rate is the estimated percent of a loan or an obligation that will still be repaid to creditors in the event of a default or bankruptcy.
- In a firm’s capital structure, the recovery rate on senior debt will generally carry a high recovery rate, while junior debt may be relegated to a rate as low as nearly zero.
- Following the wave of defaults following the 2008 financial crisis, the average recovery rate for senior unsecured bonds dropped from 53.3% in 2007 to 33.8% in 2008.
Understanding Recovery Rates
Recovery rates can vary widely, as they are affected by a number of factors, such as instrument type, corporate issues, and macroeconomic conditions. The type of instrument and its seniority within the corporate capital structure are among the most important determinants of the recovery rate. The recovery rate is affected by the instrument’s seniority in the capital structure, which means that senior debt will usually have a higher recovery rate than junior debt.
Corporate issues include the company’s capital structure, amount of equity, and level of indebtedness. Debt instruments issued by a company with a lower level of debt in relation to its assets may have higher recovery rates than a company with substantially more debt. For example, the recovery rate on senior secured bonds will often have a high recovery rate, while holders of junior subordinated bonds can expect a recovery rate of close to zero.
Macroeconomic conditions include the stage of the economic cycle, the overall default rate, and liquidity conditions. If a large number of companies are defaulting on their debt—as would be the case during a deep recession—then the recovery rates may be lower than during normal economic times. For example, a Moody’s Investors Service study, “Corporate Default and Recovery Rates, 1920–2008,” found that “the average recovery rate for senior unsecured bonds dropped from 53.3% in 2007 to 33.8% in 2008,” a result of the Great Recession that gripped the United States from December 2007 to June 2009.
Recovery Rates and Lending
In lending, the recovery rate can be applied to cash extended via loans or credit and recovered by foreclosure or bankruptcy. Knowing how to properly calculate and apply a recovery rate can help businesses set rates and terms for future credit transactions. For example, if a recovery rate turns out to be lower than expected, lenders can increase interest rates on a loan or shorten its payout cycle to better manage the added risk.
Calculating the Recovery Rate
To calculate the recovery rate, one must first choose what type of group to focus on and set a time period, such as weeks, months, or years. Once a target group is identified, add up how much money was extended to it over the given time period, then add up the total sum paid back by that group. Next, divide the total payment amount by the total amount of debt. The result is the recovery rate.
For example, during one week, you extended $15,000 in credit and received $2,000 in payments. Therefore, $2,000 ÷ $15,000 = 13.33%, which is the recovery rate for the week.
What does recovery rate mean?
Recovery rate is the percentage of defaulted debt that can be recovered by a lender. It is also the value of a security after it emerges from default or bankruptcy.
What is the value of knowing the recovery rate?
Knowing approximately how much debt you can recover is useful for setting the terms and interest rates for future credit transactions. It allows lenders to accurately account for risk.
Is the recovery rate the same for all debt?
No. It can vary greatly depending on the kind of debt in question. Generally, senior debt has a higher recovery rate than junior debt. Other factors that influence the recovery rate include corporate capital structure, type of debt instrument, level of indebtedness, and macroeconomic issues.