How do recovery rates vary by seniority in the capital structure, and why does this matter for bond investors?
CFA Level II discusses recovery rates in the context of credit analysis. I know that senior secured bonds recover more than subordinated bonds after a default, but I want to understand the typical numbers, why they differ, and how this affects bond pricing.
Recovery rates are critical for credit analysis because they determine the actual loss in a default scenario. The seniority waterfall creates dramatically different outcomes for different debt holders.
The Capital Structure Waterfall:
In bankruptcy or liquidation, creditors are paid in strict priority order. Any value remaining after paying a senior class flows to the next class down.
Historical Average Recovery Rates (Moody's Data):
| Seniority Level | Average Recovery (% of par) | Range (25th-75th percentile) |
|---|---|---|
| Senior Secured Bank Loans | 70-80% | 55-95% |
| Senior Secured Bonds | 55-65% | 35-80% |
| Senior Unsecured Bonds | 40-50% | 20-65% |
| Senior Subordinated | 30-35% | 10-50% |
| Subordinated | 20-25% | 5-40% |
| Junior Subordinated | 10-15% | 0-25% |
| Preferred Stock | 5-10% | 0-15% |
| Common Equity | 0-5% | 0-0% |
Why Recovery Rates Differ:
- Collateral — Secured debt has specific assets backing it. In a reorganization, the secured lender can seize and sell the collateral.
- Priority of claims — Absolute priority rule (APR) means senior claims must be paid in full before junior claims receive anything. In practice, APR is sometimes violated in negotiated reorganizations.
- Covenants — Senior debt typically has stronger covenants (financial maintenance tests, restricted payments) that trigger intervention before the company deteriorates too far.
- Industry — Capital-intensive industries with tangible assets (utilities, real estate) have higher recovery rates than asset-light businesses (technology, services).
Impact on Bond Pricing:
The credit spread on a bond reflects both default probability AND expected loss given default:
Credit spread ≈ PD x LGD = PD x (1 - Recovery Rate)
Example: Cortland Industries has PD = 4% for all debt tranches. But spreads differ by seniority:
| Tranche | Recovery | LGD | Expected Loss | Approximate Spread |
|---|---|---|---|---|
| Senior Secured | 65% | 35% | 1.40% | 140 bps |
| Senior Unsecured | 45% | 55% | 2.20% | 220 bps |
| Subordinated | 25% | 75% | 3.00% | 300 bps |
The 160 bps spread difference between senior secured and subordinated debt is entirely driven by recovery rate differences — the default probability is identical.
Recovery Rate Determinants:
| Factor | Higher Recovery | Lower Recovery |
|---|---|---|
| Asset tangibility | High (utilities, real estate) | Low (tech, services) |
| Leverage at default | Low debt/assets | High debt/assets |
| Economic cycle | Default during expansion | Default during recession |
| Restructuring type | Prepackaged, going-concern | Liquidation |
| Covenant protection | Strong covenants | Covenant-lite |
Exam Tip: Memorize the approximate recovery rate ranges by seniority. Be ready to calculate expected loss using PD and recovery rate, and explain why two bonds from the same issuer can have very different credit spreads.
Explore credit analysis in our CFA Level II fixed income modules.
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