Debt Structure, Market Value of Firm, and Recovery Rate

by Min Qi of Office of the Comptroller of the Currency, and
Xinlei Zhao of Office of the Comptroller of the Currency

October 2011

Abstract: This paper examines the determinants of creditor recoveries from defaulted debt instruments, an important yet under-studied area in investment and risk management. First, we argue that to properly measure a debt instrument's relative position in a firm's debt structure, debt pari passu to the instrument must be taken into account. We propose a new measure of seniority and find that it is the most important determinant of recovery rates, explaining more recovery variations than the combination of all commonly used instrument-level variables, including seniority class, collateral type, and percentage above. Second, we find that firm-level variables, especially the trailing 12-month stock returns, are more critical than industry- or macroeconomic-level variables, although the latter can also help, for private firms because stock price information is not available for such firms. In contrast with earlier studies, we find that the relative contribution of the industry and macroeconomic variables varies with the sample, model specification, and especially the modeling technique used.

JEL Classification: G32, G33, G38.

Keywords: Recovery rate, loss given default (LGD), seniority index, credit risk, debt structure.

Previously titled: Dynamic Debt Structure, Market Value of Firm, and Recovery Rate

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