Recovery Rates
Default can happen. Investors want to know how "senior" their investment needs to be in order to get their money back. Unfortunately, nothing is guaranteed.
A __recovery rate__ is the percentage of capital repaid to investors following bankruptcy and default. If an investor with a $1,000 bond ends up with $820 of repaid principal, then the recovery rate might be 82% for that debt level, in terms of seniority ranking.
Fortunately for you (and unfortunately for many investors) there is a decent amount of data on recovery rates, since there have been many bankruptcies in recent decades.
Think about the idea of average recovery rates following defaults. What would you say about the average recovery rates for two specific asset classes like senior unsecured debt and senior subordinated debt?
Exactly!
And that only makes sense, since senior unsecured debt has a higher seniority ranking than that of senior subordinated debt.
No, think about which debt level is more senior.
No. Consider that the recovery rates are averages across many defaults, not the results of a single specific default.
Here are the average recovery rates for four debt levels of nonfinancial companies in North America for defaults in 2019 and 2020, as well as a 33-year average:
| Seniority Ranking | Recovery Rate, 2020 | Recovery Rate, 2019 | Recovery Rate, 1987-2020 |
|---|---|---|---|
| Bank loans | 50% | 53% | 86% |
| Senior secured | 35% | 45% | 61% |
| Senior unsecured | 9% | 41% | 47% |
| Subordinated | 1% | 25% | 28% |
What is a bank's expected loss in loans over this 33-year time period?
No, think carefully about what the data in the table is telling you versus what the question is asking. This is not an average of all debt.
No, the banks collected 80% or so on average from defaulted loans, but consider that this is a small subset of the debt market.
That's right!
This is a little tricky, but it's important to always remember the scope of the data presented. The table provides recovery rates across all _defaults_, not across all debt issues. So an investor who somehow knows that a senior secured bond issuer will default someday can expect perhaps a 38% loss rate, but the average investment will not default at all. A small portion of issuers actually do. So the expected loss of an investment will be much less than the numbers indicated by this table of default recovery rates.
To summarize this discussion:
[[summary]]
There are a few items to consider when reviewing the data.
First, there is a lot of variance in recovery rates from industry to industry. If you need to determine some expected recovery rates, an industry average might be a better bet than an overall average.
Second, consider the business cycle. Obviously times of financial crisis will encourage more defaults and deeper losses If you are relying on an average, take this into account.
Third, these averages are affected by the volume of debt levels offered. For example, if there is a lot of senior debt offered at some point in time, then it's pretty likely that these large claims will "eat up" the assets during recovery, leading to low recovery rates for junior debt. This may not be the same case for an issue you are evaluating.
The average recovery rate for senior unsecured debt is _greater than_ the average recovery rate for senior subordinated debt
The average recovery rate for senior unsecured debt is _less than_ the average recovery rate for senior subordinated debt
If the average recovery rate for senior unsecured debt is less than 100%, then the average recovery rate for senior subordinated debt should be 0%
Less than 14% of invested capital
Approximately 14% of invested capital
More than 14% of invested capital
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