Recovery rate: average hide different realities
These days in the financial press, we often see comments about the odds of peripheral euro zone countries defaulting on their debts. The default swap market is used as a reliable source of information about those odds. Though, reader should be aware that common practice is to assume a recovery rate of 40% on defaulted bonds. This is roughly in line with historical data compiled by Moody’s on estimated recovery rate per bond by the market 30 days after default.
However, as today’s Hot charts shows, this average is derived from a distribution that is far from normal. It is skewed downward by the very large number of defaulted bonds issued by Argentina. On the other hand, if we calculate the average recovery rate per issuer, the average obtained is much higher at 56%. In the case of advanced countries, we think that the recovery rate could be even higher (see this weekly economic letter for more details).
Assuming a recovery rate of 60%, current prices in the CDS market would suggest the odds of default at 85% for Greece and nearly 60% for Ireland and Portugal, compared to the 70% and 40% often read about in the financial press. Assuming the market share our views about recovery rate for advanced economies, current CDS pricing would be consistent with default probabilities for Spain and Italy of only 25% and 16% respectively. These are lower than levels seen at the turn of the year, a comforting development.
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