Seniority Rankings and Credit Ratings | CFA Level I Fixed Income

Understanding Capital Structure and Seniority Rankings

The credit quality of a bond varies not only across different issuers but also among bonds issued by the same issuer. This variation is due to different seniority rankings, or priority of payment, of the bonds.

A company’s capital structure refers to the composition and distribution across operating units of its liabilities and equity, including bank debt, bonds, preferred stock, and common equity. Some companies have simple capital structures, while others have more complex ones with multiple subsidiaries or operating companies issuing bonds with different levels of seniority rankings.

Secured and Unsecured Debt

Debt can be broadly classified into secured and unsecured debt:

• Secured debt means the bondholder has a direct claim on certain assets and their associated cash flows.
• Unsecured bondholders have only a general claim on an issuer’s assets and cash flows.

Secured debt can be further distinguished as first lien or first mortgage, senior secured, and junior secured debt. Unsecured debt can be divided into senior unsecured debt and subordinated debt, with subordinated debt further subdivided into senior subordinated debt, subordinated debt, and junior subordinated debt.

Why Issue Debts with Different Seniority Rankings?

Issuing various types of debt serves different purposes for both issuers and investors:

• Issuing secured debt allows the issuer to lower interest costs by posting high-quality assets as collateral.
• Issuing subordinated debt can be an alternative to issuing new shares for issuers who do not want to dilute existing shares, despite the higher interest costs.
• For investors, the variety of yields provided by different ranking bonds allows them to invest according to their investment objectives.

All debt within the same category is said to rank pari passu, or have the same priority of claims. The recovery rates are highest for debt with the highest priority of claims and decrease with each lower rank of seniority. Equity holders have the lowest priority and recovery rate.

Priority of Claims and Bankruptcy Reorganization

In the event of a default, senior bondholders have claims on the assets before junior bondholders and equity holders. This is known as a waterfall structure, where higher-ranking bondholders are paid in full first before the excess flows to the next highest-ranking bondholders.

However, a strict priority of claims is not always applied in practice. Bankruptcies can be costly and time-consuming, with the value of a company’s assets potentially deteriorating during proceedings. Sometimes, senior debt holders may prefer a quick resolution and settle for less than full payment by agreeing to a bankruptcy reorganization plan. Although in theory, the priority of claims is absolute, by vote or court order, the final plan may differ from absolute priority. In many cases, lower-priority debt holders may get paid even if senior debt holders are not paid in full.

Notching and Structural Subordination

Notching is the practice of assigning different ratings to bonds of the same issuer based on factors like seniority and potential loss severity. Structural subordination can also impact notching, as parent company bonds may be effectively subordinated to subsidiary bonds due to restrictions on cash or asset transfers.

Notching is more common for lower-rated issuers, as higher default risk leads to significant differences in recovery rates between debts with different seniority levels.