Determining Recovery Ratings

Credit risk is a function of an issuer’s probability of default and the loss given default on a specific debt instrument. For noninvestment grade corporate issuers, some rating agencies assign separate ratings for these two components of credit risk. An issuer rating is a rating agency’s assessment of the probability that an issuer will default on its debt. A recovery rating, on the other hand, considers the value of assets (or enterprise value) that would be available to an investor for a specific debt instrument, in accordance with its ranking and legal rights, at the time of an assumed emergence from a reorganization or liquidation process that might occur between, for example, six and 18 months after default.

Recovery ratings can be assigned to specific instruments for corporate non-investment-grade issuers, i.e., those issuers with a speculative grade issuer rating. They are assigned because non-investment-grade bonds have a greater likelihood of default, investors have a greater interest in the outcome of a potential default scenario and an assumed default scenario can be more reliably constructed.

Criteria do not typically apply ratings on public finance transactions or financial institutions, and also not to preferred share securities that are by definition low recovery instruments. Since commercial paper or short-term instruments have by definition shorter maturity durations and a higher reliance on liquidity considerations, commercial paper is also not eligible for recovery ratings.

While the underlying security affected by a recovery rating will have a rating trend unless its status is under review, recovery ratings themselves have no trends and are not placed under review. In most cases, a recovery rating will not be maintained for very long on a security that has downgraded to Default or Selective Default.

There are five stages in the determination of a recovery rating and final instrument rating: Determination of a path to default scenario, valuation of the issuer upon emergence from default, determination of claims against the defaulted entity, distribution of value from the defaulted entity and assignment of a recovery rating and notching of the issuer rating to determine a final instrument rating.

A recovery rating necessarily assumes that a default will occur; the actual probability of default is addressed solely by the issuer rating. It is important to consider the distinction between companies that have issuer ratings in the B-category or lower and companies with issuer ratings in the BB range, since lower default risk makes it more difficult to construct a scenario for both a path to default and asset or enterprise values at default.

For BB-range issuers, a rating agency might be more restrictive in terms of the degree of notching uplift it will permit between the issuer rating and the recovery rating, so as to limit the possibility of non-investment-grade issuers having instruments rated well into investment-grade territory. The final instrument rating, determined by notching up or down from the issuer rating in accordance with the recovery rating essentially blends the two elements of credit risk — probability of default and loss given default — giving investors an additional measure of the expected performance of a non-investment-grade bond.

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