Determinants of recovery rates on defaulted corporate securities: why do fallen angels recover more than original high yield issues?

Carolyn Adler

Document Type Honors Thesis (Colby Access Only)


Credit risk plays a major role in determining the yields on corporate securities. The greater the credit risk, the risk of loss due to a company not meeting its repayment obligations, the higher the yield, and the lower the price, required to entice a buyer to purchase the given security. Financial economists, investors, banks that extend loans to companies, and companies whose access to financing changes based on their risk profile, all have a major interest in understanding the pricing of credit risk. Credit ratings given by such agencies as Moody's and Standard and Poor's assign letter values to individual securities and companies to signal the repayment risk of the given entity. Moody's investment grade credit ratings range from Aaa to Baa3 (Standard and Poor's equivalent range is AAA to BBB-). Any security with a credit rating below Baa3 is considered speculative grade, or high yield. These credit ratings are based on the calculation of "Expected Loss", the probability of default multiplied by the loss given default. This paper examines the determinants of recovery rates for defaulted corporate loans and bonds, equivalently 1 -loss given default. There are many hytheses as to why fallen angels have higher recovery rates than OHY securities. First, fallen angels may have greater asset tangibility than original high yield issues at the time of default. In theory, revenue generating tangible assets, as measured by property, plant, and equipment, have greater value than intangible assets in the event of default because intangible assets are harder to transfer to acquiring firms and may have little value if liquidated. Second, fallen angels may recover more than original high yield issues because they have superior capital structure positions. Securities positioned high up in the capital structure have less secured debt "in front of them" and often have greater collateral backing.? These two hypotheses, higher asset tangibility and stronger capital structure position, are proposed by Edward Altman as the main explanations for higher fallen angel recovery rates? Both factors can be measured at the time of default. To the best of my knowledge, no past study has investigated which of the current hypotheses do, in fact, explain higher fallen angel recoveries. Tlhis study hypothesizes that the set of quantitative factors (asset tangibility and capital structure position), and the set of qualitative factors (strategic defaults, fraud, business models, and franchising ability) both play a role in explaining why defaulted fallen angels have higher recovery rates than defaulted original high yield securities.