Seniority Rankings, Recovery Rates, and Credit Ratings

Debt seniority is the system that determines the priority of payment when a company defaults. Debt obligations vary in seniority. Some companies have simple capital structures, while others, especially those in industries impacted by regulations or acquisitions, have complex debt structures.

Seniority Rankings of Debt

Secured vs. Unsecured Debt

Secured debt Is a type of debt that has collateral (e.g., real estate, machinery) backing it. In case of a default, lenders can seize the collateral to recover their money. An example would be a mortgage, where a house serves as collateral. On the other hand, lenders of unsecured debt provide funds without any specific asset as collateral. Credit cards are common unsecured debts. Debt with a higher seniority ranking often has better credit ratings due to its priority in repayment and the security it offers to lenders.

Hierarchy of Seniority

1. First Mortgage and First Lien: These are top of the pile when it comes to debt repayment. They have the first claim on assets in case of a default.
2. Second Lien: Ranking just below the first lien, it has a secondary claim on the collateral.
3. Senior Unsecured Debt: Without specific collateral, but ranks higher than other unsecured debts.
4. Subordinated Debt and Junior Subordinated Debt: These are at the bottom of the ranking. They will only be repaid once all other debt obligations are satisfied.

Priority of Claims in Bankruptcy

When a company goes bankrupt, there’s a legal pecking order regarding who gets paid back first:

1. Secured Creditors: These lenders have the first dip into the company’s assets. If a company pledged specific assets like property or equipment to secure a loan, the lender could seize and liquidate these assets to recover its money.
2. Unsecured Creditors: Once secured creditors are paid, unsecured creditors, like bondholders or suppliers who provided goods on credit, are next in line.
3. Shareholders: These stakeholders are last in line. Common shareholders will only receive money if there are any leftover funds after all the creditors have been paid. Often, they end up with nothing.

Bankruptcy can reduce a company’s value due to associated costs, like legal fees, and operational challenges, like the loss of key personnel.

Recovery Rates

Recovery rates indicate the portion of the debt that might be recovered in a bankruptcy scenario.

Factors Affecting Recovery Rates:

1. Seniority Ranking: Senior debts usually have higher recovery rates.
2. Industry & Economy: Industries in decline tend to have lower recovery rates. Strong economies lead to higher recovery rates due to better resale value of collateral.
3. Debt Composition: An abundance of secured debt might reduce the recovery rate for lower-ranked debt.

Bankruptcy Implications

The legal standard prioritizes the highest-ranked creditors first. However, to expedite the bankruptcy process, lower seniority creditors and shareholders might receive payments. Bankruptcy can also erode company value due to legal fees, loss of key personnel, and market share reduction. Finally, bankruptcy laws and outcomes differ across countries, influencing creditor outcomes in default scenarios.

Issuer vs. Issue Ratings

Credit rating agencies often differentiate between a company’s overall creditworthiness (issuer rating) and the creditworthiness of a specific debt issue (issue rating). While the issuer rating might look at the big picture, the issue rating would consider specifics like seniority. The probability of default might be the same for an issuer and its issues. However, ratings can differ due to differences in loss-given default (LGD) stemming from factors like seniority.

Notching is a rating adjustment methodology that considers differences in loss severity. Structural subordination arises when a corporation with a holding company structure has debts at both its parent holding company and operating subsidiaries.

Role of Seniority

The seniority of a debt instrument can influence its credit rating. Senior debts are often seen as less risky and might get a higher rating compared to subordinated debts.

Rating Agencies’ Approaches

1. Moody’s focuses on both the probability of default and the expected financial loss, with their ratings primarily reflecting the expected loss.
2. Standard & Poor’s (S&P) leans more towards the probability of default in its credit ratings. They issue separate recovery ratings to indicate relative seniority and expected loss.
3. Fitch aligns more with S&P, offering Issuer Default Ratings reflecting a probability of default view and making rating adjustments based on expected recoveries for specific issues.

Question

Which of the following debt types Is most likely to have the lowest priority in the event of a company bankruptcy?

1. First Mortgage.
2. Senior Unsecured Debt.
3. Subordinated Debt.

The correct answer is C.

Subordinated Debt is at the bottom of the seniority rankings and will only be repaid once all other debt obligations are satisfied.

A is incorrect: First Mortgage is at the top of the debt repayment hierarchy.

B is incorrect: Senior Unsecured Debt, while it doesn’t have specific collateral, still ranks higher than Subordinated Debt.