What Is Recovery Rate?
Let me explain to you what the recovery rate is. It's the principal and accrued interest on defaulted debt that you can recover, expressed as a percentage of the face value. This rate also shows the value of a security when it comes out of default or bankruptcy.
Key Takeaways
You need to know that the recovery rate reflects the percentage of a loan or obligation that gets repaid to creditors in cases of default or bankruptcy. To calculate it, you divide the total amount repaid by the total balance of the loan. In a firm's capital structure, senior debt usually has a higher recovery rate.
Formula
You can calculate the recovery rate for an individual loan or a group of loans over a specific period. This helps you evaluate loan product performance and make adjustments. To get the recovery rate, divide the amount repaid so far at the time of default, including any funds recovered after bankruptcy or default, by the total balance of the loan or bond.
The formula is: Recovery Rate = Total Amount Repaid / Total Balance of the Loan.
For example, suppose a bank loans $200,000 to a business, which is the total owed including interest. The business pays $40,000 over two years, then goes bankrupt and stops payments. You divide $40,000 by $200,000 to get 0.2, so the recovery rate is 20%.
Measuring Loss
The recovery rate helps you estimate the loss from a default, known as loss given default (LGD). You calculate LGD with this formula: (1 - Recovery Rate) * Exposure at Default = Loss Given Default (LGD).
If the recovery rate is 60%, the LGD is 40% (1 - 0.60). For a $10 million debt instrument, the estimated loss from default would be $4 million.
Ultimate Recovery
Recovery is the value you receive on defaulted debt. Companies in default either emerge from bankruptcy or get liquidated. Ultimate recovery is the settlement value you get if you hold the instrument through its emergence from default.
What Affects Recovery Rates?
Recovery rates depend on the type of instrument, corporate issues, and macroeconomic conditions. The seniority of the instrument in the capital structure affects it—senior debt usually has a higher recovery rate than junior debt. For instance, senior secured bonds often recover a lot, while junior subordinated bonds might recover very little.
Corporate factors include the company's capital structure, equity, and debt level. Debt from a company with lower debt relative to assets may have higher recovery rates than one with heavy debt.
Macroeconomic conditions involve the economic cycle stage, overall default rates, and liquidity. In a deep recession with many defaults, recovery rates can drop. A Moody’s study from 1920–2008 showed that average recovery for senior unsecured bonds fell from 53.3% in 2007 to 33.8% in 2008 due to the Great Recession.
How Do Lenders and Businesses Use Recovery Rates?
The recovery rate is the percentage of defaulted debt you can recover as a lender. It's also the value of a security after default or bankruptcy. You can use it to determine the estimated recovery value of an asset in liquidation.
How Do Recovery Rates Affect Lending Practices?
In lending, you apply the recovery rate to cash from loans or credit recovered via foreclosure or bankruptcy. Knowing it helps you set rates and terms for future transactions. If recovery rates are low, you might raise interest rates or shorten payout cycles to handle the risk in new loans.
Is the Recovery Rate the Same for All Debt?
No, it's not. Senior debt generally has a higher recovery rate than junior debt. Other influences include corporate capital structure, debt instrument type, indebtedness level, and macroeconomic issues.
The Bottom Line
The recovery rate is a percentage of the face value, reflecting the principal and accrued interest on defaulted debt that you can recover. You use it to determine the estimated recovery value of an asset or debt instrument in liquidation or bankruptcy.
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