Recovery Rates: The Search for Meaning
by Martin S. Fridson of Merrill Lynch,
M. Christopher Garman of Merrill Lynch, and
Kathryn Okashima of Merrill Lynch
March 13, 2000
Introduction: The subject of recoveries on defaulted bonds 1 has been generating a lot of inquiry recently. Interest in the subject has been stimulated, no doubt, by 1999's unusually low average recovery. The weighted average price after default was just 28.66% of face value, according to Altman (2000). That was well below the 1978-1999 average of 40.19%. Similarly, Moody's, Keenan, Hamilton and Berthault (2000), characterized 1999 recovery rates as below average, although within one standard deviation of the historical average. Surveying the evidence, portfolio managers wonder whether they should expect below-average recoveries in 2000, as well.
As we shall argue, annual variance in the recovery rate is a matter of little consequence to most high yield investors. Attempting to forecast the figure therefore represents a questionable use of their resources. Short-run fluctuations in the recovery rate have somewhat greater (but not vital) importance to investors in collateralized bond obligations (CBOs). Not even CBO buyers, however, should hang their hats on short-run forecasts of the recovery rate. The seemingly obvious, logical factors with which most pundits would attempt to explain fluctuations in the recovery rate may have less impact than plain, old-fashioned statistical noise.
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