Distressed Debt Prices and Recovery Rate

Estimation

Robert Jarrow
Joint Work with Xin Guo and Haizhi Lin

May 2008
 Introduction

Recent market events highlight the importance of

understanding credit risk.
Credit risk pricing and hedging involves understanding:
1. interest rates (stochastic discounting),
2. default process (when payments stop), and
3. recovery rate process (what happens after default).
Points 1 and 2 well-studied.
Point 3, less so...
 Introduction

Three sources of knowledge on recovery rates.

1. Industry papers:
estimate recovery rates (not transparent, not validated by
academic community), and
study their properties (correlation with business cycle,
dependence on …rm characteristics, ...)
2. Academic papers - use industry generated recovery rates to
study their properties.
3. Academic papers - use pre-default debt and CDS prices to
implicitly estimate recovery rates.
 Introduction

Potential problems with existing knowledge.

Are we sure recovery rates are estimated correctly? If not,

then...
academic papers study mis-speci…ed estimates,
academic papers have no base to compare implicit estimates.
 Introduction

Purposes

Primary- provide direct estimates of recovery rates using

distressed debt prices.

Secondary - …t a model for defaulted debt prices.

(it turns out, to solve one, must also solve the other)
 Introduction

Results
1. Recovery rate estimates are sensitive to the date selected for
estimation (signi…cant di¤erences between using the recorded
default date and 30 days after).
2. Prices support the belief that the market often recognizes
default before default is recorded.
3. An extended recovery rate model provides a poor …t to
distressed debt prices after the recorded default date
(extension implicit in using 30 day after to estimate recovery
rate).
4. We estimate a new recovery rate process and use it to price
distressed debt. The model …ts market prices well.
 Prologue
Structural models
Use management’s information set.
Default can be viewed as the …rst hitting time of the …rm’s asset
value to a liability determined barrier.
If the …rm’s asset value follows a continuous process, the value of a
…rm’s debt does not exhibit a jump at default.
No implications for risky debt prices subsequent to default.
Reduced Form Models
Use market’s information set.
Default modeled as the …rst jump time of a point process.
Debt prices exhibit a negative jump at default.
No implications for risky debt prices subsequent to default.
 Prologue
55
s e ri e s 1

50

45

40

35

30

25

20

15

10
3 0 -S e p -2 0 0 4 2 7 -F e b -2 0 0 5 2 7 -J u l -2 0 0 5 2 4 -De c -2 0 0 5

Figure: Delta Airlines. Bankruptcy on September 14, 2005.

Consistent with the standard structural model.

30-day di¤erent from default date.
 Prologue
100
s e ri e s 1

90

80

70

60

50

40
0 3 -Oc t -2 0 0 4 3 0 -No v -2 0 0 4 2 7 -J a n -2 0 0 5 2 6 -M a r-2 0 0 5

Figure: Trico Marine Service Inc. Bankruptcy on December 18, 2004.

Inconsistent with the structural model.

(market recognized default earlier?)
30-day approximately same as default date.
 Prologue
100
s e ri e s 1

90

80

70

60

50

40
2 9 -Se p -2 0 0 4 2 6 -Fe b -2 0 0 5 2 6 -J u l -2 0 0 5 2 3 -De c -2 0 0 5

Figure: Winn Dixie Stores. Bankruptcy on February 21, 2005.

Consistent with the standard reduced form model.

30-day di¤erent from default date.
 Prologue
90
s e ri e s 1

80

70

60

50

40

30

20
0 3 -Ap r-2 0 0 5 3 0 -J u n -2 0 0 5 2 6 -Se p -2 0 0 5 2 3 -De c -2 0 0 5

Figure: Northwest Airlines. Bankruptcy on September 14, 2005.

Partially consistent with both the reduced form and structural.

30-day di¤erent from default date.
 Set Up
Fix a particular …rm.
Let Bt denote the price of its risky debt (a particular issue
with a given maturity, coupons (‡oating or …xed), and
embedded options).
De…ne the economic default date τ as the time when the
market knows default has happened.
The recorded default date τ where τ τ is given in our
data set.
Let Btd denote the risky debt price given economic default has
already happened, i.e. for t τ, Btd = Bt .
Let rt be riskless spot rate of interest.
Let pt (T ) be price of a riskless coupon bond with the same
maturity T and coupons as the risky bond under
consideration.
 Cross-Sectional Models

1. Recovery of Face Value (RFV):

Bτd = δτ F

where F is the face value of the debt (normalized to $100)

2. Recovery of Treasury (RT):

Bτd = δτ pτ (T )

3. Recovery of Market Value (RMV):

Bτd = δτ Bτ
 Cross-Sectional Models

Purpose of these models is to provide the necessary inputs to

price risky debt and credit derivatives prior to default.
Recovery rate estimation procedure is:
…x a defaulted company
…x a date τ to observe debt prices, then
estimate the recovery rate.
Single point estimate of the recovery rate per company. Look
cross-sectionally across companies to obtain estimate.
For example, Moody’s uses "30-day" post-default date for τ.
 Data
December 2000 to October 2007.
Debt Price Data - Advantage Data Corporation - Trade data
and broker quotes to get end of day prices 4:45 p.m.
Filter data:
have 50 prices over a 60 day window surrounding recorded
default date.
Remove bond issues with missing data on maturity, coupons.
This leaves 96 issues remaining for recovery rate estimation.
Filters imply that all our defaulted debt issues eventually …le
for bankruptcy (potential selection bias).
Bond Characteristics - Mergent Fixed Income Database.
Default is when a debt issue violates a bond covenant, misses
a coupon or principal payment, or …les for bankruptcy. A
grace period of 30 days must usually pass before default is
recognized for a missed coupon.
 Data - Bankruptcy Time Analysis

To get a sense for duration of distressed debt market, considering

only issues that …le for bankruptcy.

N = 1902 Mean Std. Dev. Median N λ

Chapter 7 433.22 353.20 433 9 0.80
Chapter 11 454.34 427.08 354 631 0.84

Time in Bankruptcy in Days

λ is average time spent in bankruptcy in years.
 Cross-sectional Recovery Rates (RFV)
Di¤erence Count Avg. Price Std. Dev. Avg. Ratio
-30 23 62.19 33.04 1.3199
-20 58 48.99 28.06 1.3510
-10 27 66.74 28.60 1.2382
-5 51 40.42 25.81 1.2114
-2 41 44.60 29.99 1.0541
-1 61 45.05 29.55 0.9796
0 70 48.17 29.39 1
1 71 45.48 28.67 1.0292
2 63 41.27 28.85 1.0284
5 44 48.32 31.48 1.0341
10 45 54.62 28.83 1.0933
20 46 53.86 32.44 1.1473
30 64 42.31 29.30 1.0779
RFV at recorded default 48.17 statistically di¤erent from RFV at 30 day
42.31.
 Cross-sectional Recovery Rates (RT)

N = 96 RT Estimates
Mean 0.4062
Median 0.3452
Standard Deviation 0.2528
First Quartile 0.1692
Third Quartile 0.6374

Lower than the RFV estimates because otherwise identical default

free bonds trade at a premium (> $100).
 Cross-sectional Recovery Rates (RMV)

N = 96 Pre-Default Default Date RMV Estimates

Mean 48.4 48.6 1.0230
Median 39 38.5 1.0013
Standard Deviation 30.6 30.7 0.1824
First Quartile 21.5 22 0.9681
Third Quartile 67.55 69.375 1.0597

Debt prices do not jump on the default date.

Implies that, on average, the debt is "riskless."
Anomalous result:
either the RMV is a poor model for recovery rates, or
the recorded default date does not equal the economic default
date.
 Time-Series Models
Rt
Btd = m δτ e τ rs ds

where 8
< F if RFV
m= pτ (T ) if RT
:
Bτ if RMV .
Assumes that risky debt position is sold at τ, and the model prices
debt as the value of this position. Equivalently,
Rt
Btd = Bτd e τ rs ds
for t τ.

This form is independent of model type. Use this to:

1. Determine economic default date.
2. Test accuracy of valuation model.
Time-Series Models - Economic Default Date

Given our de…nition of the economic default date, using debt

prices, our estimator is:

Rτ
b
τ= inf ft : Bt Bτd e t rs ds
g.
τ 180 t τ

Bound below by 180 days before the recorded default date.

Our estimator depends on the information up to time τ .
Time-Series Models - Economic Default Date

Time Between Economic Default Date and Announced Default Date

25

20

15
Cases

10

0
0 20 40 60 80 100 120 140 160 180
Days

Figure: N = 73.
Time-Series Models - Revised Recovery Rates

8 Bτ
>
< F if RFV
b Bτ
δτ = p (τ,T )
if RT
>
: Bτ
Bτ if RMV .
 Time-Series Models - RFV

N = 73 Economic Default Recorded Default

Mean 0.4879* 0.5283
Median 0.45 0.5782
Standard Deviation 0.3044 0.3151
First Quartile 0.2 0.2225
Third Quartile 0.76 0.8425

*P value essentially zero.

 Time-Series Models - RT

N = 73 Economic Default Recorded Default

Mean 0.3970* 0.4335
Median 0.3291 0.4776
Standard Deviation 0.2461 0.2600
First Quartile 0.1578 0.1803
Third Quartile 0.6031 0.6610

*P value essentially zero.

 Time-Series Models - RMV

N = 73 Economic Default Recorded Default

Mean 0.8314* 1.0653
Median 0.9094 1.0217
Standard Deviation 0.1775 0.1729
First Quartile 0.7267 0.9976
Third Quartile 0.9649 1.0854

*P value essentially zero.

This is consistent with a jump on the economic default date.

 Time-Series Models - RMV

Recov ery of Market Value Estimates Based on Economic Def aults

Recov ery of Market Value Estimates Based on Announced Def aults
7

4
Density

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Recov ery Rate Estimates
 Time-Series Models - Pricing Tests

Rt
Btd = m b
δτ e τ rs ds + et for t τ.

"Good" if the residuals have zero mean, and are i.i.d.

N = 20,942 Pricing Errors

Mean 17.81
Median 9.31
Standard Deviation 28.06
First Quartile 0.11
Third Quartile 30.00

Very large pricing errors.

 Time-Series Models - Pricing Tests

Run for each bond issue the time-series regression

et = α + βt and test if α = 0 and β = 0.
103 bond issues in our sample.
For 87 we reject the null hypothesis that α = 0 and β = 0
with a signi…cance level of 0.01 (for 79 we have negligible
P-values).
77 out of 103 issues produce positive slopes.
Rejects distressed debt pricing model. Why? Ignores
information on default resolution after τ.
Provides additional rejection of using the 30-day recovery.
 The Recovery Rate Model

Database limitations - model the resolution of the bankruptcy

…ling.
Restrict to t τ.
Let τ 0 represent the time to resolution of bankruptcy.
Exponential distribution with parameter λ.
Dollar payo¤ equal to m δτ0 0 where
8
< F if RFV
m= pτ (T ) if RT
:
Bτ if RMV .
 The Recovery Rate Model

Assume that distressed debt trades in the standard continuous

time arbitrage free setting.
Rτ
0
Btd = mE δτ0 e t rs ds
jFt
Z ∞ Rs
ru du λ (s t )
= mE δs e t λe ds jFt
t

where E ( ) is expectation under equivalent martingale probability

measure.
 The Recovery Rate Model
De…ne Rs
ru du
Rs δs e τ

where
dRt = a(b Rt )dt + σdWt
with a, b, σ are constants and Wt is a standard B.M. under the
martingale measure.

Distressed debt price:

Rt λ ba
Btd = me τ ru du Rt +
(a + λ ) (a + λ )
λ ba Rt
= m δt + e τ ru du
(a + λ ) (a + λ )
 Recovery Rate Model - Estimation Methodology
Estimate λ = 0.80 using bankruptcy data.
Given τ = τ , estimate (a, b, σ, ρ) and (Rt )t τ using Kalman
Filter:
Btd R t ru du
e τ = At + Ht Rt + et
m
where et N (0, ρ) is i.i.d. observation error.

Rt = Ct + Ft Rt 1 + ηt
2
where η t σ
N (0, 2a (1 2e a) and
ba λ a a
At , Ht , Ct b (1 e ) , Ft e
(a + λ ) (a + λ )
Given (a, b, σ, ρ, λ) and (Rt )t τ, estimate
Rτ
ru du a (τ t)
τ= inf ft : Bt Bτd e t e + mb (1 e a (τ t)
)g
τ 180 t τ
Recovery Rate Model - Economic Default Date

Time Between Economic Def ault Date and Announced Def ault Date
35

30

25

20
Cases

15

10

0
0 20 40 60 80 100 120 140 160 180
Day s

Figure: N = 82.
 Recovery Rate Model - Parameters

N = 21,083 a b σ ρ
Mean 5.03 0.5558 1.33 0.009232
Median 2.04 0.6183 0.23 0.008507
Std Dev 14.10 0.2778 5.97 0.001082
First Quartile 0.65 0.3052 0.047 0.000834
Third Quartile 4.28 0.7966 0.84 0.01319
 Recovery Rate Model - Recovery Rates

Average Recovery Rate Estimates

0.75

0.7
Recovery Rate Estimates

0.65

0.6

0.55

0.5

0.45

0.4
0 50 100 150 200 250 300 350 400
Number of Days After Economic Default
 Recovery Rate Model - Recovery Rates

RFV RT RMV
N = 69 EM KFM EM KFM EM KFM
Mean 0.4814 0.5068* 0.3919 0.4134* 0.8272 0.8868**
Median 0.4006 0.55 0.3204 0.4698 0.9 0.9299
StdDev 0.3029 0.2985 0.2442 0.2423 0.1780 0.1255
25 % 0.2 0.23 0.1578 0.1830 0.7267 0.8074
75 % 0.71 0.785 0.6020 0.6150 0.9577 0.9743

At economic default date.

Recovery Rate Model - Pricing Tests

N = 21,083 Pricing Errors in Dollars

Mean 0.0018
Median 0.0000
Standard Deviation 0.4611
First Quartile .0124
Third Quartile 0.0153

Face Value $100

 Recovery Rate Model - Pricing Tests

Run for each bond issue the time series regression

et = α + βt and test if α = 0 and β = 0.
For 83 out of 103 issues, we fail to reject the null hypothesis
that α = 0 and β = 0 with signi…cance level 0.01.
We perform a Durbin-Watson autocorrelation test.
For 62 out of the 103 issues, we fail to reject the null
hypothesis that corr (et , et 1 ) = 0 with signi…cance level 0.01.
For most issues, recovery rate model …ts data well.
 Epilogue
80
series1

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30

20

10
29-Sep-2004 09-Aug-2005 19-Jun-2006 29-Apr-2007

Figure: Delta Airlines

 Epilogue
100
series1

90

80

70

60

50

40
03-O ct-2004 30-Nov-2004 27-Jan-2005 26-Mar-2005

Figure: Trico Marine Service Inc.

 Epilogue

110
series1

100

90

80

70

60

50

40
30-Sep-2004 30-Jun-2005 30-Mar-2006 28-Dec-2006

Figure: Winn Dixie Stores

 Epilogue

110
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30

20
03-Apr-2005 22-Dec-2005 11-Sep-2006 01-Jun-2007

Figure: Northwest Airlines

 Conclusions

Economic default date di¤ers from reported default date.

Recovery rate estimates based on 30 days after recorded
default are misspeci…ed.
Recovery rate estimates based on recorded default date
signi…cantly di¤erent from economic default date.
Implies that:
Existing academic studies using 30 day recovery rates, results
quantitatively incorrect, but qualitatively?
Recovery rate estimates can be improved.
Time to economic default estimates can be improved.
Prices of credit derivatives and pre-default risky debt can be
improved.
Exploring these implications await subsequent research.