A recovery swap is a type of agreement that allows parties to swap or exchange a fixed recovery rate for a real recover rate. This normally takes place when some type of credit event has occurred that makes the swap a viable approach for the parties concerned. Sometimes known as a recovery lock, this type of exchange is more likely to occur when the credits involved are nearing a point of default.
One of the easiest ways to understand how a recovery swap works is to consider a company that has issued bonds in the past, but is now experiencing cash flow issues that have a negative impact on the liquidity of the business operation. Here, the focus is on what type of percentage the company will ultimately pay on each of those currently active bond issues. Assuming that the recovery swap is issued at a price of zero, the strategy only comes into play if the company defaults on the bonds. If the company does default, then the swap commences and the investors do at least recoup a portion of their investments, although the chances of receiving anything above the principal are extremely slim.
Typically, recovery default swaps compose a portion of the marketplace that focuses on bond issues which do carry a relatively high potential for going into default. Speculators who are willing to assume the risk can choose to buy into the issues. If the bonds ultimately do not go into default, they lose nothing. Should the issuing companies be unable to honor the terms of the bonds and go into default, then the speculator stands to lose a portion of his or her investment if the original investor does exercise the recovery swap.
While a recovery swap does help to offset the risk associated with default to some degree, investors typically do well to go with bond issues that are guaranteed. The guarantee is normally in the form of insurance that is taken out on the bond issue and maintained by the issuer. With an insured bond issue, the investor is assured of at least recouping the original investment, and may also make at least some return on the investment, even if the bond does ultimately go into a default situation. The presence of this type of protection is often considered important by issuers, since an insured bond is much more likely to attract attention from investors than bond issues that do not carry insurance, even if there is no real anticipation of default at some point before the issue reaches maturity.