What is Recovery Rate?
Recovery rate, commonly used in credit risk management, refers to the amount recovered when a loan defaults. In other words, recovery rate is the amount, expressed as a percentage, recovered from a loan that is unable to settle the full outstanding amount. A higher rate is always desirable. Although the rate is typically used for debt defaults, it can also be used for account receivables defaults.
Formula for Recovery Rate
- Amount Recovered is the dollar amount that the issuer received over the period of the loan.
- Amount Loaned is the amount that the issuer loaned out.
Factors that Affect the Recovery Rate
When looking at factors that can affect the recovery rate, the most notable factors are poor macroeconomic conditions and business issues.
1. Macroeconomic conditions
Poor macroeconomic conditions significantly affect the recovery rate for loans. Recovery rates are typically lower during a severe economic recession. During poor macroeconomic conditions, businesses face reduced profitability and a greater risk of defaulting on its debt. For example, consider the following scenario:
ABC Company is facing profitability issues and will default on its loan in the coming year. The outstanding amount is $1,000,000. In a strong economy, the company is able to generate $900,000 to pay off its loan. In a weak economy, the company is only able to generate $300,000.
As illustrated above, for a company that is expected to default on its debt, poor macroeconomic conditions decrease the recovery rate as the company is generating fewer profits to settle its debt.
2. Business Issues
Business failure caused by unforeseen business issues impacts the recovery rate. For example, a catastrophic fire that results in the inability to conduct business may result in the company defaulting on its debt, hence impacting the recovery rate. In short, business issues that affect a company’s ability to conduct business and generate profits play a key role in the recovery rate.
Recovery Rates Within a Capital Structure
Debt that is more senior within a capital structure offers a higher recovery rate. It is due to the senior debt being accorded more claims to assets as opposed to debt ranked lower in the capital structure. In a data report issued by Moody’s, the average corporate debt recovery rate in 2017 was 81.3% for loans, 52.3% for senior secured bonds, 52.3% for senior unsecured bonds, and 4.5% for subordinated bonds. To illustrate the fact, consider the following example:
A company is facing bankruptcy and owns $500,000 in distributable assets to senior secured debt holders and subordinated debt holders. Senior secured debt holders are owed $700,000 while subordinated debt holders are owed $1,000,000. What is the recovery rate for the two different debt holders?
Senior debt holders are given a higher priority in the capital structure. In other words, assets must first be distributed to senior debt holders before subordinated debt holders are paid. Since senior debt holders are owed $700,000 and the company only holds $500,000 in assets, all assets of the company are given to senior debt holders for a recovery rate of 71%. Subordinated debt holders are left with no assets, as they’ve already been distributed, and face a recovery rate of 0%.
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