Using Market Implied Ratings to Enhance Recovery in Default

Abstract

Estimates of recovery rates for defaulted debt obligations are key inputs for a wide variety of applications. In this ViewPoints piece we demonstrate how Moody's Market Implied Ratings (MIR) data can help refine estimates and predictions of recovery rates for defaulted bank debt and bonds. Briefly, we find: The shapes of the probability densities of firm-level recovery rates - vital data for risk management - vary by the sign of the bond-implied gap. Firms with negative bond-implied ratings gaps have experienced higher average recovery rates relative to those with zero and positive gaps, while the volatility of recovery rates is similar for negative, zero, and positive gap firms. Basel II has stimulated a focus on measuring credit losses over the credit cycle, with particular emphasis on recovery rates in an economic or credit downturn scenario. Bond-implied gaps reveal different sensitivities of firm-level recovery rates to the phase of the credit cycle. Issuers with positive bond-implied gaps experience more frequent departures from absolute priority rule (APR) compared to issuers with zero or negative bond-implied gaps. APR departures have a very large impact on the bank debt of issuers with positive ratings gaps, reducing their recovery rates by over 40%. Bond-implied ratings help investors identify which pieces of debt may be over- or under-priced relative to their discounted ultimate recovery value. We find that bank debt is consistently under-priced, particularly those with negative bond-implied gaps (see cover chart). Subordinated bonds are consistently over-priced on the default date.