Is Recovery Risk Priced in Debt Contracts? The Roles of Bank Regulation, Corporate Governance and Credit Rating

We investigate whether recovery risk has affected the spread of debt contacts in the U.S. market. Using the actual realized recovery rates of defaulted debt instruments, we find that recovery risk is associated with the price of debt contracts, and this relationship is stronger for non-investment grade and weak corporate governance firms and more significant after commercial banks were allowed to participate in the underwriting business. We also control for endogeneity, potential omitted variables, individual effect for bank loans and corporate bonds, and model specification issues. Our results indicate that information asymmetry, market efficiency and legislative regime are important determinants for this pricing relationship.