Recovery of Face Value at Default: Empirical evidence and implications for credit risk pricing
by Rajiv Guha of the London Business School
January 14, 2003
Abstract: We examine defaulted bonds of predominantly US-based issuers who at the time of the initial default event had several publicly traded bonds outstanding. We find that in the vast majority of cases bonds of the same issuer and seniority are valued equally or within one dollar by the market, irrespective of their time to maturity. This strongly suggests that the amount recovered in default is best modelled as a fraction of face value at the time of default (RFV) as other assumptions, in general, cannot generate such a payoff pattern in bonds. We argue that this assumption is generated by the institutional framework which affects corporate bond pricing and thus is the only assumption with an underpinning theory. Within the context of structural credit risk models we find that the recovery value form does affect spreads and potentially to a degree as important as other institutional features which have been incorporated into structural credit risk models. This has important implications for empirical studies of credit risk which use structural models. While it has been remarked in the literature that RFV is often used in practice, up to now there has been little detailed discussion on why this should be the case nor any empirical support for such a hypothesis. In fact, some recent papers show support for alternative recovery assumptions. The results within strengthen the argument that the market incorporates (or should) RFV when valuing corporate debt securities.
Previously titled: Recovery of Face Value at Default: Theory and Empirical Evidence