this is a sentence in handbook on page 473, but the recovery rates on sovereign debt are usually lower than recovery rates on corporate debt(page 472), and the recoery rates are negatively related to default rates(page 469), so i think the sovereign debt should be rated lower than corporate debt. but why it’s higher?
You have to go back to the definitions of the terms. Recovery rates are lower for soverign debt because once a government entity decides to default on their debt, there’s not a whole lot you can do about it. With companies, you can use the courts, etc. When trying to collect from a government, it’s hard to go higher than that and request funds. On that same note, when a country’s government will back a bond, it’s seen as fairly secure - more so than a bond backed only by a company. Ceteris paribus (all other things held equal), this implies that soverign debt should have a lower default rate than the corporate bond in the same country. That’s why the bond is rated higher than soverign debt. I think the statement on page 469 is related to the movement of recovery & default rates rather than the relationship of default rates. In other words, suppose a class of securities had a recovery rate of 50% and default rate of 1.5%. If defaults were to be pushed up to 5%, you can expect that the recovery rate of the securities to be less than 50%. I don’t think it suggests that if you have two different classes of securities, where one has a recovery rate of 50% and default rate of 1.5%, and another has a default rate of 5%, you can automatically assume that the recovery rate of the second class is less than 50%. They are two entirely different sets of securities (theoretically), so the recovery rate may be more or less than 50%.
If sovereign repudiates her debts, there is not too much recourse for creditors to go after; however, sovereign also has “unlimited” capacity and power to “print” money to satisfy her obligation, not like a corporation. The willingness to pay affects LGD (1 - recovery rate) and the ability to pay affects the PD. That’s why the LGD could be high for sovereign debt but the PD could also be very low at the same time. Please refer to Bionic Turtle for the calculation of LGD and the relationship between risk-free investment and risky investment, PD and LGD: http://www.bionicturtle.com/forum/viewthread/1374/ I made some changes on the formula copied from B.T. 1+risk-free return = ((1 - probability of default) * (1 + risky return) + (probability of default * (1 + risky return) * (1 - loss given default)) It could be easily understood from the math formula. Holding everything else constant, after taking into consideration of the LGD and PD, the return of the risky investment should be equal to risk-free investment return. Assuming i, risk-free return, is constant, when LGD increases because of low recovery rate, in this case for instance sovereign debts, the PD has to be decreased to compensate to keep the constant value of i, the risk-free rate. That’s why the credit spread on the sovereign debt might not be necessarily higher than the corporate debt because of other components mentioned above and therefore sovereign debt might have a higher credit rating than corporate.
thx to the above all, i think i understand it.