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Bi-Weekly Research Service

February 22, 2007

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BIG PICTURE

Recoveries at Non-Record High

By Martin Fridson, CFA Martin@FridsonVision.com

DDI@FridsonVision.com

The high recovery rates of 2006 have created concerns about the upside potential for buyers of defaulted bonds. Pessimists suggest that this is no short-term phenomenon but rather the reflection of some fundamental change in the system. Our analysis indicates, however, that 2006s rate is not unprecedented, is within the range of statistical expectation, and probably will have only a minor effect on vulture managers returns over the next several years.
In 2006, the weighted average recovery rate, 1 or shortly-after-default price of defaulted bonds, was 65.32% of face value, as reported by Edward I. Altman of New York University. That compares with a historical median (1978-2006) of 41.77%. To hear some pundits tell it, the currently high recovery rate severely constrains the upside for buyers of bonds following default. Furthermore, the commentators reckon that the recovery rates divergence from its historical norm reflects some sort of fundamental change in the market. According to one version of this story, hedge funds are altering the system with the huge amount of capital under their management. One possible implication of high recoveries resulting from a profound alteration of the system is that vultures must expect low returns, not only over the next few years, but permanently. A closer look at the data, however, produces a less dire picture. In the first place, last years 65.32% rate does not represent a departure from the usual level of around 40%, as press accounts often suggest. Exhibit 1 shows that the recovery rate fluctuates widely over time. There is nothing unusual about a rate that is not close to 40. During the 29-year period depicted in the graph, the recovery rate was in the range of 35.0% to 45.0% only 10 times. Last years rate was high, but not a record. It was exceeded by 1987s rate of 66.63%. (In 1981, the rate was even higher, at 72.0%, but that represented an average for a single defaulting bond.)

1 In this report, recovery refers to the value of a bond shortly after default. The percentage of claim ultimately paid to bondholders at the end of bankruptcy proceedings is a topic for another day.

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BIG PICTURE Exhibit 1: Average Recovery Rate on Defaulted Debt 1978-2006

80 70

It is the exception, rather than the rule, for the recovery rate to be close to 40%

60 50 Percent 40 30 20 10 0

Source: New York University.

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Distressed Debt Investor February 22, 2007

19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 9 19 2 93 19 94 19 95 19 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 06
Year Weighted Price After Default as Percent of Face Value

Default rates have also been substantially lower than the historical median in certain years. The record low, however, was not as far below the median as the record high was above it: YEAR 1980 1987 RATE 21.67% 66.63% MEDIAN 41.77% 41.77% = DIFFERENCE -20.10% 24.86%

This sort of skewing might be expected, given that the median is below the midpoint of the possible range of outcomes (0% to 100%). The key point is that recovery rates appear to obey common statistical principles. Exhibit 2 shows that the distribution of the annual rates of the past 29 years roughly approximates a classic bell-shaped curve. The highest number of observations is in the range that includes the mean (43.69%) and generally declines in both directions from the mean. As noted in connection with the alltime highs and lows, there is some skewing toward the high end. While the sample size in Exhibit 2 is small, the graph is at least roughly consistent with a normal distribution. From a statistical viewpoint, this suggests that the annual recovery rates vary in random fashion. If so, no hypothesis involving a fundamental change in the system is required to explain 2006s farabove-average 65.32% rate. It is simply the sort of number that will be seen every so often for a statistical series with a mean of around 45 and a standard deviation of around 15%. 2 In more technical terms, 65.32% is not outside the range of statistical expectation.

2 Based on the limited number of observations, the actual standard deviation for the recovery rates of 1978-2006 is 13.89%.

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BIG PICTURE Exhibit 2: Distribution of Recovery Rates 1978-2006

12

10

Number of Years

To a considerable extent, recovery rates vary according to the level of default rates

0 <25.0 25.0-34.9 35.0-44.9 45.0-54.9 55.0-64.9 >65 Recovery Rate

Source: New York University.

Explaining Variance in Recovery Rates Suggesting that recovery rates vary randomly is not the same as saying that in a given year, the rate is equally likely to be 15 points above the mean as it is to be 15 points below the mean. In fact, Exhibit 3 suggests that the variance in recovery rates is at least partly a function of the default rate. 3 Altman and collaborators 4 fitted several different regression models to this sort of data and found that the default rate explained 54% to 65% of the variance in recovery rates.

3 The trendline is even more apparent if the following outliers are eliminated: The two most extreme points in the lower, left-hand corner, the most extreme point in the upper, left-hand corner, and points with coordinates (horizontal axis, vertical axis) of 1.78%, 60.0% and 3.84%, 38.03%. These represent years in which the number of defaults totaled less than 10, potentially creating substantial statistical noise. 4 See Edward I. Altman, Brooks Brady, Andrea Resti, and Andrea Sironi, The Link between Default and Recovery Rates: Theory, Empirical Evidence and Implications. New York University (March 2003). http://pages.stern.nyu.edu/~ealtman/Link_between_Default_and_Recovery_Rates.pdf

Distressed Debt Investor February 22, 2007

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BIG PICTURE Exhibit 3: Average Recovery Rate on Defaulted Debt versus Global Issuer-Based Default Rate 1978-2006
80 Recovery Rate on Defaulted Debt (%) 70 60 50 40 30 20 10 0 0 2 4 6 Default Rate (%)
Sources: Moodys Investors Service, New York University.

To a considerable extent, recovery rates vary according to the level of default rates

10

12

The relationship, i.e., the higher the default rate the lower the recovery rate, is Prices of defaulted bonds are likely to be consistent with intuition. comparatively high when a low default rate creates scarcity value, while a high default rate may create a glut of defaulted bonds. In addition, investors may expect bankruptcies to take longer to resolve when the bankruptcy court calendars are jammed with cases. The expectation of a long wait for the proceeds would reduce the present value of claims, as reflected in recovery rates.

Some of the variance in recovery rates reflects statistical noise

Based on the analysis of Altman, et al., at least 35% of the variance in recovery rates is not explained by variance in the default rate. (Graphically, this is indicated by the fact that the points in Exhibit 3 do not all lie along a single straight line or a smooth curve.) Several factors that do not represent fundamental shifts in the system are likely sources of the unexplained variance. Statistical noise is one such effect. For some years, the recovery rates in Exhibit 2 are calculated on very small samples of less than 10 issues. As recently as 1994, the count was a mere 24. (The highest count was 340 in 2002.) If a few companies with exceptionally high or exceptionally low recoveries account for a large proportion of a given years sample, the divergence from the mean recovery rate may be overstated.

Distressed Debt Investor February 22, 2007

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BIG PICTURE

Another source of noise is variability in the distribution of issues among priority classes with high average recoveries (senior and senior unsecured) and those with low average recoveries (senior subordinated, subordinated, and discounts/zero coupons). 5 In 2005, 81.2% of the issues were in the higherrecovery classes. The comparable figure for 2000 was only 36.6%. Such variation is merely a function of the capital structures of the particular companies that happen to default in a given year. It nevertheless contributes to year-to-year variance in the average recovery rate for all seniorities, the series depicted in Exhibit 1.

The annual recovery rate is affected by the mix of companies that happen to default and their capital structures

The identities of the companies that default in a given year create another type of noise. For a number of reasons having little to do with the year in which the default occurs, recoveries vary from company to company. Some companies, for example, have little bank debt and consequently enjoy comparatively high recoveries on their public, senior unsecured bonds. Furthermore, not all defaulting companies are equal in Altmans recovery rate calculation, because the unit of measurement is issues. Accordingly, a company with $2 billion face amount of public debt split up among just three issues has only half the impact on the statistics as a company with $500 million of public debt spread among six issues. If the bigger debtors bonds have higher recoveries, priority level for priority level, than the smaller debtor, the years average recovery for all issues will be understated. Some of these effects are quite small. They nevertheless underscore the challenges of aggregating the data in such a way as to produce a series that can be analyzed on the basis of real economic and financial market effects. The quirks that can arise from the compilation method and the chance nature of which companies default in a given year are exemplified by anomalies that arise in some years. In 1995, for example, the mean recovery for senior secured bonds was lower (44.64%) than for senior unsecured bonds (50.50%). This result does not indicate that the bankruptcy court abandoned the rule of absolute priority 6 in that year. Rather, it may result from the happenstance of high recoveries on selected companies with no senior secured public bonds outstanding and low recoveries on other companies with senior secured public bonds outstanding and no (or fewer) senior unsecured public bonds outstanding.

Industry effects have proven hard to document

Finally, the concentration of a given years defaults in a certain industry is widely assumed to be capable of skewing the recovery rate. Empirical research has not generated a lot of support for this hypothesis, however. Even though many analysts consider it obvious that certain industries known for hard assets provide comparatively high recoveries, it has proven surprisingly difficult to find consistent relationships between industry and recovery in the data.

5 Altman reports recoveries on discount and zero-coupon bonds separately, even though each such issue can be classified in one of the other four priority classes. Including discounts and zeros in the other classes, however, would require calculating their accreted values at the point of default. Instead, Altman calculates recoveries for the discounts and zeros as a percentage of face value (100). 6 The common definition of absolute priority is that a bankrupt firm's value is to be distributed to suppliers of capital such that senior creditors are fully satisfied before any distributions are made to junior creditors, and junior creditors are paid in full before common stockholders. (Source: Eberhart, A.C., W.T. Moore, and R.L. Roenfeldt, 1990, Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings, Journal of Finance [December 1990], 14571469.) See however,: Brooke Smith, Much Ado about Nothing: Absolute Priority Deviations in Chapter 11, Financial Management, Special Issue: European Corporate Finance (September 22), 1996. http://www.encyclopedia.com/doc/1G1-19161964.html The author characterizes the foregoing formulation as a laymans version that lacks certain nuances of the actual legal definition.

Distressed Debt Investor February 22, 2007

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BIG PICTURE

Readers should also bear in mind that regression models are prone to underestimation at the highs and to overestimation at the lows. The expected recovery rate for 2006, according to Altman et al.s preferred log-linear model was 55.1%, fully 10 percentage points below the observed rate of 65.32%. To some extent, the surprisingly high recovery rate of 2006 simply reflected the limitations of available statistical methods, not fundamental changes in the system. Implications of Ordinary Cyclical Variance If we are correct in believing that last years comparatively high recovery rate indicates no fundamental change in the system, vultures who are fretting about future returns can relax. The 2006 rate applied to just 50 issues, the lowest count since 1998. That year, like 2006, was near the beginning of a default rate cycle. The 34 defaulted issues of 1998 represented only 3.6% of the issues that defaulted between that year and the cyclical peak in 2002.

The high recoveries of 2006 will probably have a negligible effect on full-cycle returns for distressed investors

Because the 1998 defaults represented such a small portion of the periods defaults through the peak year, they had little impact on the longer-period recovery rate. A similar pattern can be expected in coming years. The defaulting issues of 2006, with their high average recovery rates, will probably represent a small percentage of the full cycles defaulting issues. Vulture funds were forced to get in at high levels last year, but gains on the issues they bought should have only a modest impact on the returns they will earn over the multiyear lives of their funds. Later in the cycle, we feel confident, buyers of defaulted bonds will see average entry points in the 20s, providing plenty of upside for their funds investors.
DDI

Distressed Debt Investor February 22, 2007

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DISCLOSURES REGARDING RESEARCH REPORT

The views expressed about the debt securities that are the subject of this research report accurately reflect the personal views, as of the reports publication date, of the Gordian Group Inc. (Gordian) analyst primarily responsible for drafting the report. No part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by him in this research report. The analysts evaluation of the subject debt securities may change subsequent to the publication of this report. Neither the analyst nor Gordian assumes any duty to update the information contained in this report. This research report is for informational purposes only and does not provide individually tailored tax, legal, or investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The debt instruments discussed in this research report may not be suitable for all investors. Gordian strongly recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investors individual circumstances and objectives. Therefore, any decisions you make based upon any information contained in this research report are your sole responsibility. Under no circumstances is this report to be used or considered as an offer to sell or a solicitation of any offer to buy any equity or debt security or any options, futures or other derivatives related to such securities. If you do not agree with these terms, please delete the publication.

Distressed Debt Investor February 22, 2007

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