Recovery rates on defaulted corporate bonds continued the upward trajectory in 2003 that began last year after hitting an historic bottom in 2001, according to a new report by Moody’s Investors Service.

After peaking at around 50% of par value in 1997, recovery rates fell to a low of around 25% in 2001. However, “recovery rates picked up in 2002 and are now approaching their long-term average of roughly 40%,” says Moody’s vice president Praveen Varma, the primary author of the report.

The report investigates various factors that affect recovery rates on defaulted instruments and offers bond investors insights to historical and expected recovery rates. “Given the vast amount of additional data that has come with the extraordinary number of defaults in the past few years, “says Varma, “the report is timely as it offers a more granular view of recovery rates.”

The report finds that defaulted bonds of issuers rated investment grade any time during the five years prior to default had higher average recovery rates than those for issuers rated speculative grade.

Many factors affect recovery rates. For example, the seniority of a debt instrument in capital structure plays a significant role — the higher the seniority, the better the recovery. However, the report also finds that the initial event that classifies an issuer as being in default also influences recovery rates. For example, recovery rates for issuers consummating distress exchanges are significantly higher than the recovery rates for issuers filing for bankruptcy protection. “By agreeing to restructure their claims, bondholders sometimes enable companies to avoid the bankruptcy process, which can be costly and can further dilute the ultimate value of the bonds,” says Varma.

The report also finds that recovery rates have been highest in the utility industry. They have been lowest in the telecom and steel industries, industries at opposite ends of the technology spectrum but facing similar challenges, including overcapacity, fierce competition and declining prices.

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