The link between default and recovery rates: Theory, empirical evidence, and implications

This paper analyzes the association between default and recovery rates on credit assets and seeks to empirically explain this critical relationship. We examine recovery rates on corporate bond defaults over the period 1982-2002. Our econometric univariate and multivariate models explain a significant portion of the variance in bond recovery rates aggregated across seniority and collateral levels. We find that recovery rates are a function of supply and demand for the securities, with default rates playing a pivotal role. Our results have important implications for credit risk models and for the procyclicality effects of the New Basel Capital Accord. © 2005 by The University of Chicago. All rights reserved.