Seniority, recovery rates and notching

If a company defaults, who gets paid first?

A seniority ranking is the order in which a defaulted company’s creditors are paid. The most senior debt has the first claim on the issuer’s cash flows and assets, and the level of seniority drives how much an investor gets back. That order is the priority of claims .

The first divide is between secured and unsecured debt. Secured debt is a direct claim on specific pledged assets (the collateral). If the borrower defaults, the lender can take the assets and sell them, which reduces its loss. Unsecured debt is only a general claim on the company’s assets and cash flows.

Claims on a defaulted companypaid in order; each class is paid in full before the next gets anything (in theory)

• Secured debt Memorize a pledge on specific assets; lower LGD
  • First mortgage / first lien Memorize highest priority on the pledged property or assets
  • Second lien Use it same assets, paid after the first lien
• Unsecured debt Memorize a general claim on the company; higher LGD
  • Senior unsecured Memorize the most common corporate bond
  • Senior subordinated Know the idea first among the subordinated classes
  • Subordinated Memorize paid after senior debt
  • Junior subordinated Memorize lowest ranked debt; often little or no recovery
• Shareholders Memorize preferred first, then common; paid only after all debt

Among secured lenders, first mortgage debt is a pledge of specific property (a power plant for a utility, say). First lien debt is a pledge of certain assets that could include buildings, equipment, licenses, patents, brands or inventory. Second lien debt has an interest in the same pledged assets, but ranks below first lien debt in both collateral protection and payment priority.

Among unsecured lenders, senior unsecured debt is the highest-ranked and the most common corporate bond. Subordinated debt and junior subordinated debt rank below it and often recover little or nothing. Shareholders come last of all, after every creditor. Issuers use the whole range to match different investors’ demands and to manage their cost of capital: secured debt is cheaper for the issuer, subordinated debt is cheaper than equity and does not dilute owners.

Three rules inside the ladder

Memorize

1. A collateral shortfall becomes an unsecured claim. If the pledged assets sell for less than the secured claim, the difference ranks with the senior unsecured creditors. (If they sell for more, the surplus goes back to the pool for everyone below.)
2. Same class, same treatment. Creditors at one seniority level are one class, whatever their maturity, and share pari passu (equally, pro rata). A six-month senior unsecured note and a 30-year senior unsecured bond have the same claim.
3. One default is every default. A cross-default clause makes a default on one obligation a default on the others, so all of an issuer’s unsubordinated debt has the same probability of default. Differences between bonds therefore come from loss given default alone.

In real bankruptcies the order is not always strictly followed. Resolution takes time and costs money (legal fees, lost staff and customers), so claimants negotiate, and lower classes sometimes receive more than their legal entitlement to speed the process up. Some countries favor reorganization, others liquidation. Treat the ranking as the exam’s rule and the negotiations as the real-world exception.

Who recovers what?

The recovery rate is the share of a claim that comes back in default. It rises with seniority because the priority of claims decides who is repaid before the money runs out.

$$RR = \dfrac{V - \min(C, S)}{U + \max(S - C,\, 0)}$$

Here V is the total liquidation value, S the secured claim, C the collateral’s value and U the senior unsecured claims. It assumes the subordinated and equity classes are paid only if something is left over.

What moves recovery rates?

Use it

• Seniority. Secured debt recovers more than senior unsecured, which recovers more than subordinated.
• Industry. Industries in long-term decline recover less because their assets are worth less when sold.
• The credit cycle. In strong economies collateral can be resold at good prices and recoveries are higher. In recessions collateral is hard to sell and recoveries fall.
• The capital structure. A lot of secured debt leaves less for lower-ranked debt.

Recovery rates are averages with wide variation, so an analyst uses them as a guide for loss given default, not a promise.

How does seniority change expected loss?

Because every class of debt has the same probability of default but a different recovery rate, expected loss differs by class. That is the expected-loss formula from the credit risk lesson, applied one class at a time.

$$EL = POD \times (1 - RR)$$

How do ratings reflect seniority?

Rating agencies usually publish two kinds of rating. An issuer rating speaks to the company’s overall creditworthiness and usually applies to its senior unsecured debt. An issue rating speaks to one specific obligation and takes its seniority into account.

Because of cross-default the probability of default is the same for every issue, but loss given default is not. Adjusting an issue’s rating up or down from the issuer rating to reflect that is called notching .

Ratings of one companysame POD for all its debt (cross-default), different LGD by seniority

• Issuer rating Memorize overall creditworthiness; usually the senior unsecured rating
• Issue ratings Memorize a specific bond; reflects its seniority
  • Secured debt Memorize notched up from the issuer rating
  • Senior unsecured Memorize no notch: equals the issuer rating
  • Subordinated debt Memorize notched down from the issuer rating
• Size of the notch Memorize bigger when the issuer rating is lower
• Structural subordination Use it parent-level debt can be rated below subsidiary debt

The notch is bigger for lower-rated issuers. If default is unlikely, a difference in what you lose after a default has little effect on the bond’s overall risk, so the notch is small or zero. If default is likely, that difference matters a great deal, so agencies apply larger adjustments. Notching always starts from the issuer rating, never the sovereign rating.

Structural subordination

Use it

Many companies, such as media groups, utilities and banks, have a parent holding company and operating subsidiaries that each issue debt. The subsidiaries’ debt is paid from the subsidiaries’ own cash flow and assets first. Only what is left can be passed (upstreamed) to the parent to service its debt. That puts the parent’s debt in a weaker position even when both are nominally “senior unsecured”, which is called structural subordination , and agencies may rate it lower.

Exam tip Three questions for any rating-gap question: same issuer? (then same POD) Which rank? (then LGD) How low is the issuer rating? (then notch size).

Go deeper How the three big agencies treat recovery differently

Agencies share the aim of measuring credit risk, but they build recovery in differently. One reflects expected loss, so recovery is part of the rating itself, particularly for speculative-grade debt. Another bases its ratings mainly on the probability of default and publishes a separate recovery rating by issue, which it can also use in notching. A third assigns issuer default ratings from a default view and then notches issue ratings for expected recovery. The exam point: the rating scales differ in design, but each uses seniority and recovery to separate a company’s bonds.

Go deeper Why both secured and subordinated debt exist

Issuers want the cheapest funding mix and investors want different risk and return. Secured debt gives lenders a safety margin, so it costs the issuer less. Subordinated debt costs more than senior debt but less than equity and, unlike new shares, does not dilute existing owners. Each rank is a product aimed at a different investor. Securitization, covered in later modules, takes the idea further by carving a pool of loans into seniority classes on purpose.

Go deeper When the strict order bends

In theory, absolute priority means each class is paid in full before the next receives anything. In practice, a long bankruptcy burns value through fees and departing customers and staff, so senior creditors sometimes accept that juniors receive a little to end the dispute sooner. Reorganization-friendly systems tend to see more of this than liquidation-oriented ones. For exam purposes, use strict priority unless the question says otherwise.