Is Recovery Risk Priced?

The finance literature looks at a number of factors to explain risk premia in corporate debt, such as liquidity effects, jump-to-default risk, and contagion risk. Stochastic re-covery rates as a source of systematic risk have not received much attention so far, most likely due to the difficulties around decomposing the expected loss. In this paper, we exploit the fact that differently-ranking debt instruments of the same issuer face identical default risk but different default-conditional recovery rates. This allows us to isolate implied recovery without any of the rigid assumptions employed by priors. Our results suggest that there is a pronounced systematic component in recovery rates for which investors should receive a premium. By relating our estimates to physical realizations, we make this premium explicit and find it to be quite time-stable and similar for different debt seniorities