Structural recovery of face value at default

Abstract

A Recovery of Face Value at Default (RFV) means receiving the same fractional recovery of par at default for bonds of the same issuer and seniority, regardless of remaining maturity. We find that RFV in a parsimonious structural credit risk model has a profound impact on hedging interest rate risk as it strongly affects model sensitivities to interest rates. In particular, RFV explains and quantifies two important stylized facts: i) the low empirical duration of high-yield bonds and ii) the decreasing sensitivity of credit spreads to interest rates as credit quality declines. The recovery form used in empirical studies influences their interpretation as the default-free term structure (level and slope) interacts with the recovery form in determining model credit spreads.

Estimating Loss Given Default from CDS under Weak Identification

“…The term structure of loss given default, also called the LGD curve, is given by {L j,t : j = 1, ...40}, where L j,t is defined as the time-t risk-neutral expectation of the proportional loss of face value of the underlying bond, given default j quarters from time t. Note that this definition is the commonly used loss convention fractional recovery of face value (or par value). 17 Guha and Sbuelz (2005) provide empirical evidence supporting this loss convention, and it is the most natural choice given CDS contract wording. 18 Under the model assumptions above, the present value of the CDS premium leg is…”

“…18 Guha and Sbuelz (2005) show that after a default event, bonds of the same seniority are observed to recover the same proportion of bond face value, irrespective of maturity. This empirical fact is generally only consistent with the fractional loss of face value framework.…”