I don't have specific knowledge with these wearables. I used to work at an AT&T retail store managing our inventory. Returned devices and accessories as well as extra inventory of end-of-life items that were no longer offered for sale were shipped back to our warehouse.
I don't really have detailed knowledge of what happened from there, but my understanding is that working devices were sold back to the manufacturer to be refurbished, which might include replacing scratched/worn housing and having the firmware reset to factory settings.
Outside of the 14 day return policy, we didn't handle warranty replacements in the store for phones, but we did for accessories. We would send items like chargers and cases that had begun falling apart due to normal wear and tear in for recycling.
My guess is that Microsoft salvages and refurbishes what they can from returned items. They have sent me some obviously refurbished Bands as warranty replacements. Their supply of units to be refurbished has to come from somewhere, and this seems like the most logical source.
For items that are physically damaged, such as torn strap, loose battery wire inside the strap, water damaged circuits, etc., they probably have a way or a vendor who can scrap these items for recycled materials.