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Low Recovery Rates for Investors in Bankrupt Companies
S&P report shows that the recovery rates for investors has fallen in recent years. Investors are getting back smaller percentages of their investments in companies that have gone bankrupt.
In a nutshell, the conclusion S&P draws in its report is that while recovery rates for those invested in companies that go bankrupt vary widely depending on several factors, they have fallen significantly in recent years, across the board. To understand this better, it is helpful to start at the beginning, and consider the company in the years before its bankruptcy. Most companies in the market, especially large ones, operate with a fair amount of debt. They may have lines of credit, short or long term loans, and they may have sold bonds to investors with a promise to pay them back later or over a period of time. These bonds, in particular, can be attractive to investors because they are “fixed income,” and have a scheduled payout (as opposed to buying a company’s stock). It is normal, and even encouraged for a company to operate with some or all of these forms of debt, until that is, these debts become too large (or revenue becomes too small) for the company to sustain, at which point it may file for bankruptcy.
The question then becomes, what happens to those the company owes money to after it goes bankrupt? The answer is that their loans, bonds, etc become “defaulted instruments.”
Of course, the exact recovery rate for any investor depends primarily on the type of debt, with certain types of debt receiving priority over others during the bankruptcy process. Lines of credit, for example, are generally repaid before bonds, and thus have a significantly higher average recovery rate. Certain “senior bonds” also receive priority over others during the repayment process. However, one thing that all defaulted instruments have in common is this: the faster a company recovers, regains profitability, and emerges from bankruptcy, the higher their recovery rate will be. This, of course, makes sense given that companies earning more revenue are naturally more equipped to repay their debts. It also helps to explain why recovery rates have fallen in recent years.
The first factor S&P cites in explaining the recent fall in recovery rates is the recession, a so-called “macroeconomic”
Let us consider a company called ABC Inc.They are bankrupt, and thanks to the recession, it doesn’t look like they’ll be returning to profitability any time soon. Basically, their bondholders know there is very little chance that they will be able to repay anything close to the original value of their bond; they are expecting VERY low recovery rates. As a result, ABC Inc.’s bonds aren’t worth much: a $100 bond can only be sold for $10 on the market. In a distressed exchange, ABC Inc. would allow their investors to trade in their bonds for $20 (or some other number above market value) in exchange for new ones. These new bonds would have a later maturity date, allowing ABC Inc. more time to (hopefully) work their way out of bankruptcy and pay them back. Many investors, especially recently, have settled for this type of deal with the expectation that it is probably the best that they can expect to get. As a result, the number of distressed exchanges has skyrocketed in recent years, and recovery rates have fallen. For the most part, this is simply another fall-out from the recession, but it does help to explain the recent fall in recovery rates, especially for bonds.
Page Updated Last on: Oct 17, 2012