Implications of Default Information Leakage on Recoveries

Abstract

Using time-series recoveries implicit in 334 defaulted bonds issued by bankruptcy-filing firms in the United States, this article examines the influence from default information leakage on the recovery process. By distinguishing default from bankruptcy filing, results show that the recoveries shortly after default or filing can substitute for each other; however, neither is a good estimator for the recovery at bankruptcy resolution. Results document the assembled determinants that drive the level of recoveries postdefault. Characterizing a higher value of changes in recoveries are reductions in credit quality, issuance amount or macro condition, or rises in asset size, or market awareness of default information leakage. As bondholders perceive default-relevant information earlier than the formal filing, distressed bond trading activities originating from the pressure to sell intensify with high transaction costs, decreasing the expectation on recoveries at filing. Alternatively, this brings in positive influence on the recoveries at bankruptcy resolution and magnifies the changes in recoveries for disvalued bonds.

TOPICS: Project finance, statistical methods, credit risk management

Key Findings

• • By distinguishing default from formal filing, our article confirms that the recoveries shortly after default or fling can substitute for each other; however, neither is a good estimator for the recovery at bankruptcy resolution.

• • As the market perceives default information leakage, distressed bond trading activity originating from the pressure to sell leads to lower expectation on recoveries at the instant of filing.

• • Alternatively, it brings in higher ultimate recoveries, resulting in large deviation in recoveries at filing with bankruptcy resolution.