How are recovery rates estimated and why do they vary so much across different types of debt?

Recovery rate is the percentage of face value that bondholders actually receive when an issuer defaults. It's central to credit analysis because Expected Loss = Probability of Default x Loss Given Default, where LGD = 1 - Recovery Rate.

The Priority Waterfall: Why Seniority Matters

When a company defaults, its remaining assets are distributed according to the absolute priority rule — a strict hierarchy:

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Typical Recovery Rates by Seniority (Historical Averages):

Factors That Drive Recovery Rate Variation:

1. Collateral quality — A loan secured by prime commercial real estate recovers more than one secured by specialized manufacturing equipment with limited resale value.

2. Industry — Utilities and regulated industries tend to have higher recoveries (tangible assets, regulated cash flows). Technology and service firms often have lower recoveries (intangible assets like IP and brand value are harder to liquidate).

3. Economic conditions at default — During recessions, asset values are depressed and more firms default simultaneously, flooding the distressed market. Recovery rates drop across the board.

4. Capital structure complexity — Firms with many layers of debt (secured, unsecured, mezzanine, convertibles) tend to have lower recoveries for junior tranches because more claimants compete for limited assets.

5. Jurisdiction — US bankruptcy law (Chapter 11) generally allows for reorganization, which can preserve going-concern value. In some jurisdictions, liquidation is the default outcome.

Practical Example — Kendrick Automotive

Kendrick defaults with $500M in remaining enterprise value:

• $200M Senior Secured: Recovers 100$200M)
• $300M Senior Unsecured: Recovers 100$300M from remaining value)
• $150M Subordinated: Recovers 0% (nothing left)

Recovery rates: Secured = 100%, Unsecured = 100%, Subordinated = 0%.

Now change the enterprise value to $350M:

• Secured: Recovers 100% ($200M)
• Unsecured: Recovers 50% ($150M of$300M)
• Subordinated: Recovers 0%

Exam Tip: For CFA Level I, know that Expected Loss = PD x LGD, and that LGD varies primarily with seniority and collateral quality. Questions often ask you to rank recovery expectations across debt tranches.

Explore credit analysis frameworks in our CFA Level I study materials.