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FRM Part I · FRM Exam Part I · Corporate Bonds

Which statement best describes the empirical relationship between default rates and recovery rates on corporate bonds, as documented in credit research?

Recovery rates tend to be lower when aggregate default rates are high, so the two are negatively correlated. In downturns asset values fall and many distressed firms sell similar assets, depressing recoveries. Treating recovery as independent or constant therefore understates credit losses during stressed periods.

  1. ARecovery rates tend to be lower in years when aggregate default rates are high, so recovery and default are negatively correlatedCorrect
  2. BRecovery rates are independent of the default rate because they depend only on bond coupon
  3. CRecovery rates tend to be higher in years when aggregate default rates are high because more assets are liquidated
  4. DRecovery rates are constant across seniority classes and economic cycles

Explanation

Empirical studies find a negative correlation between default rates and recovery rates: in recessions, collateral values fall and many firms in distress sell similar assets, lowering recoveries. Assuming independence understates risk in downturns. Recoveries also differ strongly by seniority.

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