Pricing Defaulted Bonds - Evidence from Markets, CDS Auctions and Ultimate Recovery

Abstract

I examine pricing of bonds at Credit Event Auctions which are used to calculate settlement payouts on Credit Default Swaps underwritten on issuing rms that have triggered a credit event. Secondary market prices of bonds along with those discovered at the auction are estimates of terminal recovery on these securities which is conventionally referred to as ultimate recovery. I use hand-collected data on ultimate recovery on these bonds to jointly test for bias in prices at the auction and in secondary markets. I nd that Credit Event Auctions are biased in a manner consistent with theory and generate prices that, on average, underestimate ultimate recovery resulting in higher payouts to buyers of credit protection. Moreover, bond prices in secondary markets are more informed about ultimate recovery before the auction than after it suggesting that existence of open CDS positions enriches the information environment for these bonds.