Credit Policy

Special Report

Analysts
Credit Policy
Roger Merritt
1 212 908-0636
roger.merritt@fitchratings.com
Richard Hunter
+44 20 7417-4362
richard.hunter@fitchratings.com
Asia
David Marshall
+852 2263-9911
david.marshall@fitchratings.com
Banks
Ian Linnell
+44 20 7417-4344
ian.linnell@fitchratings.com
James Moss
1 312 368-3213
james.moss@fitchratings.com
Corporates
John Olert
1 212 908-0663
john.olert@fitchratings.com
Trevor Pitman
+44 20 7417-4280
trevor.pitman@fitchratings.com
Insurance
Keith Buckley
1 312 368-3211
keith.buckely@fitchratings.com
Greg Carter
+44 20 7417-6327
greg.carter@fitchratings.com

Recovery Ratings: Exposing the

Components of Credit Risk
Summary
Fitch is launching its new recovery ratings (RR ratings) and issuer
default ratings (IDRs), following a commentary period that involved
extensive feedback from investors and other market participants. The
commentary period was extended to provide time to incorporate all of
the markets feedback and respond to the analytical challenges of
applying recovery ratings globally across all sectors. Having gathered
this feedback, Fitch has begun the process of converting its issuer and
issue ratings to reflect the new methodology.
The new ratings will be rolled out during the rest of 2005, starting in the
near term with the Corporate sector (Industrials), and followed during the
remainder of the year by financial institutions, sovereigns, insurance and
distressed structured finance securities. Published RR ratings will be
assigned for all corporate, financial institutions and sovereign issuers rated
in the single B category and below. Published RR ratings for these
sectors will be established using a bespoke analysis comparing distressed
enterprise values against a given securitys position in the capital structure.
Within global structured finance, RR ratings will be assigned to
distressed and defaulted bonds rated B and lower on the basis of specific
stress tests and cash flow analysis.
We take this opportunity to thank all the respondents to the
consultation paper and encourage continued feedback as
implementation of these new ratings continues. Fitch is committed to
providing the highest levels of transparency and innovation in its
ratings, and we believe this initiative creates a framework for more
clearly separating the two primary components of credit risk.
Market Feedback
In February, Fitch published an exposure draft titled, The Role of
Recovery Analysis in RatingsEnhancing Informational Content and
Transparency, in order to solicit market input. In this report, Fitch
specifically requested feedback on three main questions.

Sovereigns
David Riley
+44 20 7417-6338
David.riley@fitchratings.com

1.

Do market participants perceive benefits from more clearly

articulating the role of recoveries in ratings through the
adoption of a formal recovery scale?

Structured Finance
Olivier Delfour
+33 1 44 29 91-21
Olivier.delfour@fitchratings.com

2.

Does the publication of a pure probability of default rating

(IDR) for issuers, in conjunction with greater information on

Marion Silverman
1 312 368-3167
marion.silverman@fitchratings.com

For additional information on this topic, please see Fitch criteria

reports The Role of Recovery Analysis in Ratings Enhancing
Informational Content and Transparency, dated Feb. 14, 2005, and
Recovery Ratings: Developing an Effective Methodology for
Banks, dated Sept. 27, 2005.

July 26, 2005

www.fitchratings.com

Credit Policy
Recovery Ratings Scale*
RR1
RR2
RR3
RR4
RR5
RR6

issuer obligations nonetheless supported publication

of RR ratings for the obligations of low investmentgrade (BBB and BBB rated) issuers.

Outstanding recovery prospects given default.

Superior recovery prospects given default.
Good recovery prospects given default.
Average recovery prospects given default.
Below-average recovery prospects given default.
Poor recovery prospects given default.

Fitch intends initially to publish recovery ratings only

for the obligations of corporate, financial institutions
and sovereign issuers rated B+ or below, and for
distressed/defaulted structured finance securities
rated B or lower, to concentrate its efforts on low
speculative-grade issues initially where the likelihood
of default is higher and recovery values are more
meaningful. We will continue to gather feedback
following the initial implementation of the recovery
ratings, and a future extension of published ratings to
include BB and higher rated issuers is possible in
time.

*Recovery ratings reflect assumptions about relative recovery

expectations rather than precise estimates. Fitch does employ
recovery bands in its ratings approach based on historical
averages, but actual recoveries for a given security may deviate
materially from historical averages.

recoveries,
improve
the
informational content of ratings?
3.

overall

Would it be beneficial if the recovery scale

was applied across all sectors of the debt
markets, including higher rated issuers?

Should the ratings reflect present value or

ultimate recovery?

Fitch held numerous meetings with investors, bankers

and other participants. In the course of these meetings
as part of the consultation process, Fitch received
many comments on these questions and other details
of the proposal. The most commonly discussed items
are summarized below.

Respondents were evenly split on this topic, with the

exception of a small number of investors who
requested both types of information. Those in favor
of ultimate recovery were attracted by the ability to
use their own in-house expectations on the average
time to recovery and, more importantly, the ability to
use their own cost of capital as a discount factor.
Other investors preferred the value of Fitch making
central assumptions on these topics. For its corporate
analysis, Fitch will focus primarily on ultimate
recoveries, although the recovery analysis will use
stressed cash flow scenarios and realistic enterprise
valuations. For structured finance, market feedback
concurred with Fitchs view that cash flow streams
are more predictable and easier to model, making a
present value approach more appropriate for some, if
not all, asset classes and structures. Sector-specific
recovery methodologies will be published in concert
with the incorporation of this methodology and
recovery scale.

Are there benefits to clearly highlighting

recoveries through adoption of a recovery
scale?

The response was overwhelmingly favorable, as most

viewed these changes as enhancing the informational
value of Fitchs ratings by more specifically
highlighting the two main components of credit risk.
Perhaps unsurprisingly, no respondents replied that
they would rather not see recovery information more
clearly defined. Integration of the recovery analysis
directly into the ratings and consistent application
globally across all sectors were seen as particularly
valuable.

Should there be wider notching based upon

recovery?

Should RR ratings be published for the

obligations of BB and higher rated
issuers?

Only one respondent believed that the notching of

less speculative obligations as proposed (+/2 for
investment grade, +/3 for BB speculative grade)
was insufficient. All other respondents concurred
with Fitchs view that, given the greater volatility in
recovery expectations, the limited available pool of
reliable recovery data in most markets and the
innovative nature of the product, limiting the
notching at higher ratings levels was prudent and
appropriate.

Respondents generally expressed an interest in

having recovery ratings published further up the
ratings scale, not just for the obligations of B+ rated
issuers and below. While there was strong support for
assigning RR ratings to obligations of BB rated
issuers, responses were almost evenly divided over
the idea of assigning RR ratings to the obligations
of investment-grade rated issuers. A number of
respondents who did not generally support
publication of RR ratings for investment-grade
Recovery Ratings: Exposing the Components of Credit Risk
2

Credit Policy
Indicative Ratings for Distressed and
Defaulted Issues
Recovery Scale
RR1
RR2
RR3
RR4
RR5
RR6

for issuers and, in most cases, will be set at the

issuers current long-term credit rating or senior
unsecured rating.

Potential Issue Ratings

CCC+/B/B
CCC/CCC+
CCC/CCC
CC/CCC
C/CC
C

In the past, individual obligations were rated on the

basis of established notching policies. RR ratings
are being introduced to define better the role of
recoveries in rating securities and bring more
transparency to this important element of credit risk.
RR ratings are based on a relative scale measuring
potential recovery values in bankruptcy, liquidation
or some other form of restructuring and range from
RR1 (highest) to RR6 (lowest). RR ratings are
on an ordinal scale and, given the numerous factors
influencing recoveries over time, the scale does not
attempt to predict a precise percentage recovery.

Should there be more categories in the RR

rating scale?

Respondents were uniform in their desire to have a

recovery scale that offers sufficient differentiation to
be useful but which does not offer unrealistic
granularity. There was some support for a scale that
distinguished those obligations that benefited from
extremely solid security and high recovery prospects
(such as utility mortgage bonds) as an RR0.
However, support for this concept was not
unanimous, so the banding proposed in the initial
proposal for RR1RR6 has been retained.

Each corporate or sovereign obligation will thus have

three relevant ratings: a benchmark probability of
default rating (IDR), a recovery rating (the RR
rating) and an obligation rating that combines the
two. For example, a security deemed to have
outstanding recovery prospects (greater than 90%)
from an issuer with an IDR of B, might be rated
BB based on its expected loss characteristics. As
the IDR falls closer to default, the notching between
the IDR and the securitys rating may widen to reflect
the strong recovery prospects in default or,
alternatively, low loss given default.

Will Fitchs recovery methodologies and

assumptions be transparent?

The theme of transparency was a common one during

the consultation process. Fitch has devoted
significant effort to ensuring that the methodology on
recovery ratings is as transparent as possible by
publishing detailed criteria by major sector.
Additionally, key assumptions for published recovery
ratings will be provided as often as possible, and the
ratings will be updated as necessary, subject to
information availability.

It is important to note that Fitchs obligation ratings

are not expected loss ratings in the purest sense. Pure
expected loss ratings would permit obligations of
weak or defaulted issuers with outstanding recovery
prospects (i.e., a high default probability but a loss
given default of very nearly 0%) to be rated at or
close to AAA. By continuing the market practice of
notching down from the issuer rating for belowaverage recoveries and by limiting the benefit to a
rating of potentially high recoveries, Fitch recognizes
the inherent limitations in placing undue reliance on
recoveries and has opted to retain a bias in its ratings
toward timeliness over recovery. Nevertheless, by
providing the two componentsa benchmark
probability of default and a recovery expectation
given defaultFitch is providing information for
market participants to weigh each factor according to
their own needs.

Overview of Recovery Ratings and

IDRs
Fitch has long recognized the importance of
recoveries in its rating methodologies. This is
evidenced, for example, by the different ratings
assigned to securities of an issuer, reflecting their
relative seniority and likely recoveries in the event of
a default. That said, recovery analysis has taken on a
more prominent role in credit risk management,
necessitating enhanced analytical approaches and
additional information.

For corporate finance and sovereigns, an IDR will be

assigned to most issuers and counterparties, and will
reflect the issuers ability to meet senior financial
commitments on a timely basis. The IDR is
effectively a benchmark probability of default rating

Recovery Analysis for Low SpeculativeGrade Corporates

The recovery for B+ and lower rated issuers will be

published and based on explicit estimates of recovery
Recovery Ratings: Exposing the Components of Credit Risk
3

Credit Policy
Recovery Scales Effect on Issue
Ratings of Performing Companies*

value. To construct these explicit estimates, Fitch

analysts use assumptions on enterprise value (either as
a restructured going concern or as liquidation value)
and on creditor mass for an entity assuming the
stresses that may provoke a default. Detailed bespoke
analysis is carried out on the capital structure for each
issuer to take account of contractual and structural
subordination of each class of obligation.

RR1
RR2
RR3
RR4
RR5
RR6

Recovery Analysis for BB and InvestmentGrade Corporates

Investment
Grade
2
1
1
0
(1)
(1)(2)

Speculative
Grade
3
2
1
0
(1)
(2)(3)

*Indicates notching up or down for a security relative to the issuer

default rating given the securitys R rating.

The aforementioned bespoke approach is appropriate

for mid- to low-rated speculative-grade issuers but is
less so for BB or investment-grade issuers. For
these entities, their relatively strong financial profiles
and distance from default makes any assumptions
that lead to an immediate default somewhat arbitrary
and potentially misleading. RR ratings for these
issuers instead will be based primarily on long-term
average recovery expectations for that type of
security, after giving consideration to collateral
value, relative subordination within an issuers
capital structure and other determinants of recovery.

Fitchs focus more strongly toward recoveries or loss

given default as default becomes imminent. This is
consistent with how investors analyze distressed
securities and ensures the ratings are relatively
consistent on an expected loss basis (see the
Indicative Ratings for Distressed and Defaulted
Issues table on page 3).
Defaulted securities with outstanding recovery
characteristics may be rated as high as the single B
category. Such a security will have an RR rating of
RR1. For example, this could be a well-secured
corporate debt obligation where a coupon is still
being serviced but the underlying issuer is rated RD
or D, such as a covered bond issued by a financial
institution or a mortgage bond issued by a utility.

Recovery Analysis for Structured Finance

Securities

Structured finance securities will not be assigned an

IDR, as the issuer is usually a special-purpose vehicle
(SPV) established solely to issue the securities.
Individual structured finance securities will continue
to be assigned short- and long-term credit ratings
(STCRs and LTCRs). Distressed or defaulted
structured finance securities will be rated on Fitchs
revised scale of C to B (see Appendix II on page
7), and the recovery scale of RR1RR6 will also
be applied. Structured finance securities are deemed
to be distressed or defaulted when the structure is
unable to meet its future obligations, when
contractually due, assuming a very low base-case
(typically B) stress or when one or more contractual
payments are missed. A separate report describing
Fitchs recovery methodology for structured finance
will be published in the near future.

Rating Short-term Programs and

Obligations

Short-term program and obligation ratings will

continue to address exclusively an issuers ability to
meet financial commitments in a timely manner and
do not incorporate any consideration of recovery in
the event of default. In reality, most short-term
obligations are retired well in advance of insolvency,
as the short-term investor base is particularly risk
averse.
Implementation of Recovery and Issuer
Default Ratings

Fitch will begin issuing recovery ratings and IDRs on

a sector-by-sector and region-by-region basis. We
expect nonfinancial corporate ratings to be issued
first, followed by financial institutions, sovereigns,
insurance and structured finance once the
methodologies and associated fundamental recovery
research are finalized. IDRs and recovery ratings will
not be adopted for U.S. public finance and other
subnational ratings for the time being, since default
rates in this sector historically are quite low and

Rating Distressed or Defaulted Securities

A strict application of the notching table would lead

to very low issue ratings for distressed or defaulted
speculative-grade
issuers,
permitting
less
differentiation of loss given default as ratings
approach default. For this reason, notching will likely
widen out from the IDR as companies approach
insolvency for those securities with higher recovery
prospects. In part, this is a consequence of shifting
Recovery Ratings: Exposing the Components of Credit Risk
4

Credit Policy
recovery prospects will be incorporated more
explicitly and with greater transparency than in the
past. In other respects, the rating implications are
expected to be more modest for the majority of more
highly rated issuers and securities, although even for
these issuers recoveries will be incorporated more
explicitly and uniformly going forward.

investors place primary emphasis on timeliness of

payment.
In conjunction with rollouts by sector, each group is
formulating baseline recovery assumptions for their
industries and sectors, supported where necessary by
additional research. For example, the unique features
of regulated bank deposits and insurance claims are
being evaluated, along with recovery differences
between regulated operating companies and
unregulated holding companies. In each case, Fitch
expects to publish criteria that transparently explain
the analytical methodology underpinning the
recovery ratings. In some cases, it may be necessary
to revise sector-specific rating definitions (for
example, insurer financial strength ratings).

Fitch also is undertaking research to better

understand qualitative differences in insolvency
regimes by country and will use this information to
publish additional commentary and to inform the
rollout of recovery ratings in jurisdictions where
default and recovery data are less robust.
Additionally, Fitchs annual transition and default
studies will continue to fully reflect defaulted
securities on a historically consistent basis,
irrespective of any definitional changes.

At the issue level, Fitch will strive to be responsive to

investors calls for transparency by openly detailing
the key assumptions underlying the ratings. Fitch
expects to update and publish its recovery analyses in
a timely fashion, consistent with its current practices
for credit ratings. Following a default, it may be
difficult to obtain accurate, timely information for
some issuers, necessitating a withdrawal of the
ratings. However, Fitch reserves the right to maintain
it ratings post default whenever possible, provided
adequate information and market demand exist.

Conclusion
The adoption of recovery ratings and IDRs globally
will enhance the informational content of Fitchs
ratings by separating the two main components of
credit risk: probability of default and loss given
default. This type of information is increasingly
valuable in a post Basel-II world of sophisticated
credit risk management. The overwhelmingly
positive response from the market to Fitchs rollout
of recovery ratings and IDRs reinforces this view.

The most significant effect of the recovery ratings

will be on low speculative-grade issues, where

Recovery Ratings: Exposing the Components of Credit Risk

5

Credit Policy

Appendix I

While recovery ratings are in relative terms, Fitch

does employ recovery bands in its ratings approach.
RR1 rated securities have characteristics in line
with securities historically recovering 91%100% of
current principal and related interest. RR2 rated
securities have characteristics in line with securities
historically recovering 71%90% of current principal
and related interest. RR3 rated securities have
characteristics in line with securities historically
recovering 51%70% of principal and related
interest. RR4 rated securities have characteristics in
line with securities historically recovering 31%50%
of current principal and related interest. RR5 rated
securities have characteristics in line with securities
historically recovering 11%30% of current principal
and related interest. RR6 rated securities have
characteristics in line with securities historically
recovering 0%10% of current principal and related
interest.

Recovery Ratings Definitions

Fitch assigns recovery ratings to securities and issues.

These currently are published for most individual
obligations of issuers with IDRs in the B rating
category and below, and to structured finance
securities that become distressed or have defaulted
and are rated in the B rating category and below.
New issue structured finance securities typically are
not assigned a recovery rating.
Recoveries gain in importance at lower rating levels
because the likelihood of default in the near to
medium term is often quite high and differences in
recovery values have a more meaningful effect on
loss expectations. Among the factors that affect
recovery rates for an entitys security are the
collateral, the seniority relative to other obligations in
the capital structure and the companys expected
value in distress. For structured finance securities, the
combination of tranche size, relative seniority and
structural features influences recovery values.

Recovery ratings reflect Fitchs opinions about

relative recovery expectations and may deviate
substantially from historical averages for a given
ratings band. Recovery ratings can change over time
due to evolving circumstances and changing
economic and market conditions.

The recovery scale is based upon the expected

relative recovery characteristics of an obligation upon
the curing of a default, emergence from insolvency,
or following a liquidation or termination of the
obligor or its associated collateral. As such, it is an
ordinal scale and does not attempt to predict precisely
a given level of recovery.

It is important to note that new issue securities from

corporate and sovereign issuers with an IDR of B+
or lower will have a published recovery scale rating
at issue, as will issuers securities upon downgrade to
an IDR of B+ or lower. For structured finance
securities, the recovery scale ratings will only be
assigned and published post-issuance at such time as
a security becomes distressed or defaulted. New issue
structured finance securities, as well as lower rated
nondistressed structured finance securities, will not
be assigned a recovery scale rating, providing an
appropriate degree of differentiation in the market
place.

Recovery Ratings Scale

RR1 Outstanding recovery prospects given

default.
RR2 Superior recovery prospects given default.
RR3 Good recovery prospects given default.
RR4 Average recovery prospects given default.
RR5 Below-average recovery prospects given
default.
RR6 Poor recovery prospects given default.

Recovery Ratings: Exposing the Components of Credit Risk

6

Credit Policy

Appendix II

recovery rating of RR4 (average) or RR5

(below average).

Revised Ratings Definitions: Low

Speculative Grade

Fitch has also revised its ratings approach for defaulted

and distressed securities. Defaulted and distressed
securities are now rated either C, CC, CCC or, in
certain circumstances, in the B category depending
upon the securitys recovery prospects. A rating of D
will still be assigned to issuers upon default of all
obligations, and a new restricted default (RD) rating
will be used in instances when an issuer defaults on
some, but not all, of its obligations. A full description
of the revised definitions is given below. For a
complete version of Fitchs ratings definitions, visit
www.fitchratings.com.

RD

Indicates an issuer that has failed to make due

payments (within the applicable grace period) on
some but not all material financial obligations but
continues to honor other classes of obligations.

Highly speculative.
For issuers and performing obligations, B
ratings indicate that significant credit risk is
present, but a limited margin of safety remains.
Financial commitments are currently being met;
however, capacity for continued payment is
contingent upon a sustained, favorable business
and economic environment.
For individual obligations, may indicate
distressed or defaulted obligations with potential
for extremely high recoveries. Such obligations
would possess a recovery assessment of RR1
(outstanding).

Indicates an issuer that has defaulted on all of its

financial obligations. Default generally is defined as
one of the following:

CCC

For issuers and performing obligations, default is

a real possibility. Capacity for meeting financial
commitments is solely reliant upon sustained,
favorable business or economic conditions.
For individual obligations, may indicate
distressed or defaulted obligations with potential
for average to superior levels of recovery.
Differences in credit quality may be denoted by
plus/minus distinctions. Such obligations
typically would possess a recovery assessment of
RR2 (superior), RR3 (good) or RR4
(average).

Failure of an obligor to make timely payment of

principal and/or interest under the contractual
terms of any financial obligation;
The
bankruptcy
filings,
administration,
receivership, liquidation or other winding up or
cessation of business of an obligor; or
The distressed or other coercive exchange of an
obligation, where creditors were offered
securities with diminished structural or economic
terms compared with the existing obligation.

Default ratings are not assigned prospectively; within

this context, nonpayment on an instrument that
contains a deferral feature or grace period will not be
considered a default until after the expiration of the
deferral or grace period.
Issuers will be rated D upon a default. Defaulted
and distressed obligations typically are rated along
the continuum of B to C ratings categories,
depending upon their recovery prospects and other
relevant characteristics. Additionally, in structured
finance transactions, where analysis indicates that an
instrument is irrevocably impaired such that it is not
expected to pay interest and/or principal in full in
accordance with the terms of the obligations
documentation during the life of the transaction, but
where no payment default in accordance with the
terms of the documentation is imminent, the

CC

For issuers and performing obligations, default is

imminent.
For individual obligations, may indicate
distressed or defaulted obligations with potential
for below-average to poor recoveries. Such
obligations would possess a recovery rating of
RR6 (poor).

For issuers and performing obligations, default

of some kind appears probable.
For individual obligations, may indicate
distressed or defaulted obligations with a

Recovery Ratings: Exposing the Components of Credit Risk

7

Credit Policy
obligation may be rated in the B or CCCC
categories.

payment has not been made on a material obligation

in accordance with the requirements of the
obligations documentation, or where it believes that
default ratings consistent with Fitchs published
definition of default are the most appropriate ratings
to assign.

Default is determined by reference to the terms of the

obligations documentation. Fitch will assign default
ratings where it has reasonably determined that

Copyright 2005 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.
Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the
information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the
truth or accuracy of any such information. As a result, the information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to the
creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of
any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection
with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort.
Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the taxexempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees
generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured
or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The
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publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.

Recovery Ratings: Exposing the Components of Credit Risk

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