Understanding the Recovery Rates on Defaulted Securities

We document empirically the determinants of the observed recovery rates on defaulted securities in the United States over the period 1982–1999. The recovery rates are measured using the prices of defaulted securities at the time of default and at the time of emergence from default or from bankruptcy. In addition to seniority and security of the defaulted securities, industry conditions at the time of default are found to be robust and important determinants of the recovery rates. In particular, recovery in a distressed state of the industry (median annual stock return for the industry firms being less than -30%) is lower than the recovery in a healthy state of the industry by 10 to 20 cents on a dollar depending on the measure of recovery employed. The determinants of recovery rates appear to be different from the firm-specific determinants of default risk of the firm. Our results underscore the existence of substantial variability in recoveries, in the cross-section of securities as well as in the time-series, and suggest that in order to capture recovery risk, the credit risk models require an industry factor in addition to the factor representing the firm value.