The Expected Recovery Rate and the Probability of Default on High Yield Debt

Abstract

Several studies find a negative relation between the recovery rate and the default rate on high yield debt. It has been argued that this is due to inelastic demand for defaulted debt. This paper shows, based on definitional relations in the bond market, that the expected recovery rate is positively related (everything else equal) to the ex ante probability of default. Empirical evidence supports the model and indicates that it is useful in explaining the default rate as well as the recovery rate.