Industry Financial Health Impacts Recovery Rates on Defaulted Securities
ANN ARBOR, Mich.---The highly publicized bankruptcies of Enron, Kmart, Tyco, MCI and other mainstream companies have raised investor concerns about how much they will be able to recover on defaulted bonds and loans. Business scholars, too, have shown increasing interest in understanding the various factors that impact recovery risk.
In a new study, Sreedhar Bharath of the University of Michigan Business School and colleagues Viral Acharya of the London Business School and Anand Srinivasan of the University of Georgia conclude that the financial condition of the industry of the defaulting firm is an economically important determinant of recovery rates, outweighing other factors.
¿Poor industry conditions when a company defaults depress recovery rates on the defaulting company¿s debt securities,¿ says Bharath, assistant professor of finance at the Michigan Business School.
In their research, the three scholars analyzed recovery rates on defaulted loans and bonds in the United States between 1982 and 1999. Their investigation, the first systematic study on recovery rates, focused on the characteristics of contracts and firm, as well as on industry-wide and overall macro-economic conditions. Measurements were based on the prices of defaulted securities at the time of default and at emergence.
The seniority and security of debt instruments help to account for some variation in recovery rates at emergence, according to the study. Generally, securities with higher seniority and collateral backing fare better. For example, bank loans recover on average 20 cents more on the dollar at emergence than senior-secured and unsecured instruments, which in turn recover 20 cents more than subordinated instruments.
In terms of security, instruments backed by current assets recover 25 cents more on the dollar at emergence than unsecured instruments. Recoveries at emergence also are adversely affected by the length of time the firm has spent in bankruptcy.
Looking at firm-specific factors, the defaulting firm¿s profitability of assets and concentration of debt structure explain some of the differences in recovery rates at default, the researchers say. They report that profitability of assets, measured as profit margins, has a marginal effect on recoveries at default of approximately five cents on the dollar. Firms with a greater number of defaulted issues and more extensive debt dispersion, which tend to drive up bankruptcy and liquidation costs, experience a negative impact on recovery rates.
¿Our most striking results, however, concern the effect of industry-specific and macro-economic conditions in the default year,¿ Bharath says. ¿If the defaulting firm¿s industry is in ¿distress¿ (i.e., the industry¿s median stock return is down 30 percent or more that year), the firm¿s securities recover 10 to 12 cents less on the dollar than when the industry is healthy. This holds true for rate recoveries when the company defaults and later when it emerges from bankruptcy.¿
The researchers also find that poor liquidity of peer firms in the industry depresses the defaulting firm¿s recovery rates on debt at emergence, though not at default. Among industry groups, recovery rates are highest for the utility sector, which may be due to regulatory oversight.
On a macro-economic level, recovery rates are impacted by supply and demand, they say. Poor macroeconomic conditions, for example, reduce the ability of potential buyers to pay higher prices for assets. A greater supply of defaulted bonds with a limited demand can cause the prices on defaulted bonds to fall in order to clear the markets. However, macro-economic factors are not significant determinants of recoveries once industry conditions are taken into consideration.
In concluding their research paper, titled ¿Understanding the Recovery Rates on Defaulted Securities,¿ Bharath, Acharya and Srinivansan say that factors affecting a firm¿s likelihood of default also affect the recoveries on its debt instruments once the firm is in default. However, the determinants of default risk and recovery risk are not perfectly correlated, according to their findings.
¿Seniority and collateral, time in default, concentration of debt structure, industry distress and industry liquidity are factors that seem to affect recoveries over and above factors that affect default risk,¿ Bharath says. ¿Our results underscore the need for modeling recovery risk as stemming from firm-specific factors as well as systemic, industry-specific factors.¿
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