Bond contracts give holders of those bonds the right to partake legal actions when the provider of the bond fails to provide in contract terms such as promised payments. In the latter case of the bond issuer failing to make the promised bond payments, a default occurs.
In case of company liquidiation, the assets must be distibuted among the bondholders. This distribution is done following the seniority ranking. The seniority ranking creates priority among bondholders and impacts the fraction of promised payments received.
The value that the bondholder is entitled to in case of company liquidiation constitutes the bond principle and the remaining interest payments. Debt is a contract liability, meaning that debtholders have a higher priority that equity holders. However, hierarchy exists within these debt securities. The priority of claim is referred to as the seniority ranking of debt. We distinguish two types of debt securities:
- Secured debt: As debt securities are issues, assets are assured as collateral to some bondholders. Collateral are usually tangible assets that retain value in case of liquidation. The borrowing party can pledge these assets as collateral to be secured in case of default. The secured debt bondholders are the first in line to take possessions of these assets.
- Unsecured debt is not supported by collateral. As a result bondholders require higher coupon rates on that debt as the perceived risk of losing money is greater. Furthermore, there may be hierarchy between unsecured bonds. Unsecured debt with lower priority is referred to as subordinated debt. Moreover, subordinated debt may be classified, frequently distributed to senior and junior subordinated.
In conclusion, collateral reduces risk for bondholders in the event of liquidation of the borrowing party. Pledged assets can be secured in differing priorities per the seniority ranking of debt, creating a hierarchy of risk for the bondholders.
Why do companies issue debt with different rankings?
Companies issue debt with different rankings for several reasons. One is cost considerations. Typically, secured debt has a lower cost for the firm issuing it as the credit risk is lower.
Furthermore, debt is less expensive than equity from the borrowers viewpoint. The cost of issuing debt may initially be higher than the cost of equity. On the other hand, it is generally less restrictive in the long term.
Finally, investors invest in subordinated debt as it allows them to generate high yields on their investment to compensate the increased risk level.