Credit risk refers to the uncertainty associated with repayments from borrowers. When a lender provides a loan to a borrower, they expect future interest and principal repayments. However, borrowers may not fulfill their end of the bargain. For every debt transaction, credit risk will exist. Therefore, lenders always have to make provisions in case the risk realizes.
Sometimes, however, credit risks may be inevitable. Lenders will always suffer from a borrower’s inability to repay the loan. Sometimes, they may lose the full amount of the loan. In other cases, they may be able to recover a portion of the debt. For that, they can calculate the recovery rate of the debt obligation.
In a previous article, we discussed the probability of default within a structural credit risk model. In this post, we will discuss the recovery rate. Note that the recovery rate is closely tied to the Loss Given Default.
What is the Recovery Rate?
Recovery rate refers to the amount that lenders recover when a borrower defaults on loan repayments. Lenders can calculate the recovery rate of a bond or loan as a percentage of the total amount. For securities, the recovery rate may represent the value when the securities emerge from default or bankruptcy. There are several factors that may play a role in the recovery rate.
For bonds, the recovery rate shows the extent to which lenders can recover the principal and accrued interest on a defaulted bond. The recovery rate comes in the form of a percentage of the bond’s face value. Using the recovery rate, lenders can estimate the loss that they would make if the bond defaults. The higher a bond’s recovery rate is, the lower the loss will be for the lender.
How does Recovery Rate work?
As mentioned, various factors may affect a debt’s recovery rate. The credit rating of the borrower and the type of instrument play a significant role in it. Similarly, the instrument’s seniority within the issuer’s capital structure also plays a role in it. The relationship between recovery rate and instrument seniority is direct.
As mentioned, the concept of recovery rate is close to that of credit risk. The concept of recovery rate also applies to cash loans or credits that lenders recover through bankruptcy or foreclosure. Calculating the recovery rate accurately can be helpful for lenders in deciding the terms for their credit transactions. This concept applies to all loans. For example, the lower the borrower’s credit rating is, the higher the interest rate on the debt will be.
How bond Recovery Rate is calculated?
The formula to calculate the recovery rate of a loan is as below.
Recovery Rate = Amount Recovered / Loan Value
The amount recovered signifies the total repayment that the lender receives over the loan’s lifecycle. On the other hand, the loan value shows the total amount that the lender provided to the borrower.
For bond recovery rate calculation, the formula will become as follows.
Recovery Rate = Amount Recovered / Face Value of the Bond
Therefore, if a bond issuer recovers $80 on a bond with a face value of $100, the recovery rate will be 80%. Lenders can also use the above formula for a specific time period or type of bond to get more specific results.
Recovery rate is a term often associated with credit risk. The recovery rate shows the amount that lenders can recover from borrowers in case of a default. The calculation for the recovery rate is straightforward. Lenders need to calculate the amount they have recovered from debt and divide it by its total value. The higher the recovery rate is, the better it is for the lender.
For a specific case study, visit Merton Credit Risk Model, a Case Study