For stock investors, understanding the hierarchy of a company’s capital structure is perhaps less relevant, given that equity is ranked the lowest amongst the various claims on a company’s assets. In more complicated terms, equity is subordinated to other forms of claims on a company – in the event of the company’s liquidation, equity holders get paid last. However, the hierarchy of claims is far more important for bond investors, since how high or low a particular fixed income security ranks in terms of claims on a company’s assets can determine whether an investor will receive any recovery value in the case of a bankruptcy/liquidation process.
Seniority and subordination
It is perhaps useful to think of the various claims (debt, equity and other claims like wages and taxes owed) on a company as different points on an ordinal scale going from 1 to 10. Claims like employee wages and taxation are usually paid first in the event of a company’s bankruptcy, so they can be placed on one end of that ordinal scale (say 1), indicating that these are ranked highest in terms of claims on company assets. On the opposite end (10), we can place equity, which is the lowest-ranked claim. Just below this may be preferred shares of a company, which usually pay a fixed dividend (and therefore do not participate in a company’s profit growth) and usually have no maturity date.
Other claims (predominantly bonds) lie somewhere between 1 and 10 – a bond which is placed closer to 1 would be considered “senior” to another which is placed closer to 10. Conversely, the bond which is closer to 10 on the scale is termed “subordinated” or “junior” with reference to the higher-ranked bond example.
Intuitively, the primacy of certain claims over others should have a bearing on the returns expected from each segment. Not surprisingly, the lowest-ranked claims (equity) are rewarded with the highest potential returns (equity investors share the profits of a company), while the most senior debt for a company will usually have a lower yield compared to a subordinated or “junior” issue.
What this means for investors
When investing in a particular bond, investors should understand whether the bond is subordinated in nature with respect to other securities, to get a feel of where they rank on that scale of 1-10. In general, senior bonds of a company rank closer to 1 (investors may wish to look out for the use of “pari passu” to describe the equal ranking of new senior note issuance versus other senior bonds a company may have outstanding), while junior bonds are usually subordinated to some tranche of a company’s debt (this will be disclosed in the offering circular of a company’s bond issue). Given the differing primacy of claims of senior bonds versus junior bonds, it should be expected that junior bonds should offer a higher yield versus the senior bonds. As such, an investor looking at a particular company’s bonds (particularly one with both senior and junior debt tranches) should take seniority into consideration when assessing the yield of a particular bond issue.
A word on Secured debt
While our discussion has centred on unsecured debt so far, companies can also issue bonds which are secured or collateralised by specific company assets. In the event of a bankruptcy, such assets are ring-fenced from the rest of the company’s assets and used to pay this specific group of secured creditors. Including collateral in the bond arrangement usually provides a higher sense of security to the bond investor, which can allow the issuer to offer such bonds at lower yields versus unsecured borrowings (hence the investor receives a lower rate of return). However, for such securities, investors will need to assess the quality of the collateral provided and whether it will lose value in the case of a company bankruptcy. Investors should also note that the same assets can be used as collateral for various tranches of secured bonds, and that there may also be seniority and subordination of claims on these collateralised assets in the event of a default.
The Research Team is part of iFAST Financial Pte Ltd.