Recovery Rates
When a borrower defaults, lenders rarely get nothing and rarely get everything back — the recovery rate is what fraction of face value they actually recoup, and it depends heavily on seniority and collateral, not just the default itself.
Prerequisites: Credit Risk Fundamentals
Default doesn't mean a bond becomes worthless. A company that defaults usually still has assets — factories, cash, receivables, brand value — and those assets get divided among creditors through a restructuring or bankruptcy process. The recovery rate is the fraction of a defaulted bond or loan's face value that creditors ultimately get back, and it's just as important to a credit investor's expected loss as the probability of default itself.
Expected loss on a defaultable bond isn't just "will it default" — it's probability of default times how much you lose given default, and how much you lose depends heavily on where you sit in the capital structure and what collateral backs your claim.
What recovery rate depends on
Recovery is not a fixed number attached to a company — it varies by instrument, driven mainly by seniority (senior secured debt gets paid before subordinated debt) and collateral (a loan backed by specific hard assets recovers more than an unsecured bond with only a general claim). Historically, senior secured bank loans have recovered around 60-70 cents on the dollar on average, senior unsecured bonds closer to 35-45 cents, and subordinated debt often well under 30 cents — though these averages hide wide variation by industry, economic conditions, and how much total debt is stacked ahead of a given claim.
In words: loss given default is simply one minus the recovery rate — if a bond recovers 40 cents on the dollar, the loss given default is 60%.
Worked example
An investor holds $10 million face value of a senior unsecured bond trading at $92 before default (already pricing in some default risk). The issuer defaults, and after the restructuring process the bond recovers 38 cents on the dollar. The investor receives $3.8 million against $10 million face — a loss given default of 62%, or $6.2 million, considerably worse than the pre-default market price of $9.2 million might have suggested, because the market price hadn't yet converged to the actual recovery outcome until the restructuring concluded.
What this means in practice
Credit analysts build recovery assumptions directly into pricing models (CDS spreads, for instance, imply both a default probability and an assumed recovery rate) and into portfolio loss forecasts. Distressed debt investors specifically try to buy claims below their expected recovery value, effectively betting that the market is pricing in a worse outcome than the actual restructuring will deliver.
Recovery rates are cyclical, not fixed constants — they tend to fall in broad economic downturns exactly when default rates rise (more defaulting companies competing to sell similar distressed assets depresses the price each one fetches), which is why loss-given-default assumptions built during a benign credit cycle can understate real losses in a recession.
Related concepts
Practice in interviews
Further reading
- Moody's, Annual Default Study: Corporate Default and Recovery Rates