Seniority Rankings

In finance, seniority refers to the order of repayment in the event of a sale or bankruptcy of the issuer. In general, secured debt takes priority over unsecured debt if the issuer goes bankrupt. Within unsecured debt, senior debt ranks ahead of subordinated debt. The seniority ranking of securities results what is called priority of claims.

• Secured debt holders get paid first.
• Unsecured debt holders get paid before equity owners.
• Senior creditors take priority over junior (subordinated) creditors.

Why Issue Different Kinds of Debts?

The reasons are:

• the issuers are interested in optimizing the cost of capital; and
• it is less expensive to offer subordinated debt, and subordinated debt does not dilute existing shareholders.

The priority of claims is not always absolute. It can be influenced by several factors, such as government involvement, leeway accorded to bankruptcy judges, and the bias toward reorganization instead of liquidation.

Recovery Rates

Recovery rates represent the percentage of a defaulted bond's face value that investors are expected to recover during the debt restructuring or bankruptcy process. The recovery rates can vary based on various factors, including the seniority ranking of the bond.

Recovery rates for secured bonds tend to be higher compared to unsecured bonds. Depending on the quality of the collateral and other factors, recovery rates for secured bonds can range from around 70% to 100%.

Recovery rates for senior unsecured bonds typically range from around 40% to 70%. For subordinated bonds they can range from around 10% to 40%.

The actual recovery rates can vary significantly depending on the specific circumstances of each default situation, including the financial health of the issuer, the nature of the default, legal and regulatory frameworks, and other factors.

Issuer and Issue Ratings

The rating agencies rate both issuers and issues.

• Issuer ratings are meant to address an issuer's overall creditworthiness - its risk of default.
• Ratings for issues incorporate such factors as rankings in the capital structure.

Notching: A company's credit rating corresponds to its senior unsecured obligations. A rating agency may notch up secure debt from the company credit rating and notch down subordinated debt. A credit rating agency's notching policy primarily intends to reflect the relative recovery prospects of different instruments issued by the same issuer.