Rankings of Corporate Debt

Each category of debt from the same issuer is ranked according to a priority of claims in the event of a default. A bond’s priority of claims to the issuer’s assets and cash flows is referred to as its seniority ranking.

Debt can be either secured debt or unsecured debt. Secured debt is backed by collateral, while unsecured debt or debentures represent a general claim to the issuer’s assets and cash flows. Secured debt has higher priority of claims than unsecured debt.

Secured debt can be further distinguished as first lien or first mortgage (where a specific asset is pledged), senior secured, or junior secured debt. Unsecured debt is further divided into senior, junior, and subordinated gradations. The highest rank of unsecured debt is senior unsecured. Subordinated debt ranks below other unsecured debt.

The general seniority rankings for debt repayment priority are the following:

• First lien/senior secured.
• Second lien/secured.
• Senior unsecured.
• Senior subordinated.
• Subordinated.
• Junior subordinated.

All debt within the same category is said to rank pari passu, or have same priority of claims. All senior secured debt holders, for example, are treated alike in a corporate bankruptcy.

Recovery rates are highest for debt with the highest priority of claims and decrease with each lower rank of seniority. The lower the seniority ranking of a bond, the higher its credit risk. Investors require a higher yield to accept a lower seniority ranking.

In the event of a default or reorganization, senior lenders have claims on the assets before junior lenders and equity holders. A strict priority of claims, however, is not always applied in practice. Although in theory the priority of claims is absolute, in many cases lower-priority debt holders (and even equity investors) may get paid even if senior debt holders are not paid in full.

Bankruptcies can be costly and take a long time to settle. During bankruptcy proceedings, the value of a company’s assets could deteriorate due to loss of customers and key employees, while
legal expenses mount. A bankruptcy reorganization plan is confirmed by a vote among all classes of investors with less than 100% recovery rate. To avoid unnecessary delays, negotiation and compromise among various claimholders may result in a reorganization plan that does not strictly conform to the original priority of claims. By such a vote or by order of the bankruptcy court, the final plan may differ from absolute priority.