Fundamentals

of Credit
Analysis
Capital Structure,
Seniority Ranking and
Recovery Rates
Lowest Credit Quality Highest Credit Quality

Company W Company X Company Y Company Z

Bond W1 Bond Bond Y1 Bond Z1

X1423

Capital Structure, Seniority Ranking and Recovery

Rates
 Company X

Bond X0 Highest Credit Quality

Bond X1
Different
Bond X2
seniority
ranking
Bond X3

Bond X4 Lowest Credit Quality

Capital Structure, Seniority Ranking and Recovery

Rates
 Company X
Balance Sheet

Bank Debt Straightforward Capital Structure

Bonds Bond X0Bond X1Bond X2Bond X3Bond X4

All bonds are ranked equally
Assets

Preferred Stock

Common Stock

Capital Structure, Seniority Ranking and Recovery

Rates
Describe seniority rankings of corporate debt and explain
the potential violation of the priority of claims in a
bankruptcy proceeding
• Seniority ranking indicates priority of payments in case of a
winding up:

Why issue different categories of debt?

• Issuers are interested in optimizing the cost of capital
• It also may be less expensive
 Company X
Balance Sheet

Bank Debt Complicated Capital

Structure
Bond X0
Bond X1
Bonds Bond X2
Bond X3
Assets Bond X4

Preferred Stock Different levels of seniority rankings

Common Stock

Capital Structure, Seniority Ranking and Recovery

Rates
 Liquidation

Priority of Payment

Highest
Bond X0
Bond X1
Bond X2
Bond X3
Bond X4
Lowest

Different levels of seniority rankings

Capital Structure, Seniority Ranking and Recovery

Rates
 Seniority Ranking

Ranking
Highest First Lien / Mortgage

Senior Secured Bondholder has direct claim on certain

assets and their associated cash
Junior Secured flows
Secured Debt
Senior Unsecured
Unsecured Debt
Bondholder has general claim on issuer’s
Senior Subordinated assets and cash flows
W
h
Subordinated
y
s
o
m
Lowest Junior Subordinated a
n
y
?
!
Capital Structure, Seniority Ranking and Recovery
Rates
 Seniority Ranking
Issuer’s Perspective

Interest Cost
Lowest First Lien / Mortgage

Senior Secured
High quality asset
as collateral
Junior Secured

Secured Debt
Unsecured Debt
Senior Unsecured

Senior Subordinated
Alternative to
issuing new shares
Subordinated
(avoid diluting existing
shares)
Highest Junior Subordinated

Issuer
Capital Structure, Seniority Ranking and Recovery
Rates
 Seniority Ranking
I have a selection of Investor’s Perspective
risk/yield to match
my investment
objective Risk / Yield
Lowest First Lien / Mortgage

Investment grade ratings

Senior Secured
appeal to insurance
companies / pension funds
Junior Secured

Secured Debt
Unsecured Debt
Senior Unsecured

High yield bonds appeal to

Senior Subordinated
investors who seek
higher returns
Subordinated

Highest Junior Subordinated

Investor
Capital Structure, Seniority Ranking and Recovery
Rates
 All debt within the same
category is said to rank pari
passu
Ranking Priority of Claims
Highest First Lien / Mortgage
1st

Senior Secured
2nd

Junior Secured
3rd
Secured Debt
Unsecured Debt
Senior Unsecured
4th

Lowest eSn
S
J
u iuobr
5th
oSurdbionraditni eadetd
Equity
6th

Capital Structure, Seniority Ranking and Recovery

Rates
 Credit Default

Liquidation

First Lien / Mortgage

“Waterfall structure”
Senior Secured

Junior Secured

Senior Unsecured

Subordinated

Equity

Capital Structure, Seniority Ranking and Recovery

Rates
 Credit Default

Amount recovered
from liquidation

First Lien / Mortgage

Senior Secured

Amount owed to Junior Secured

bondholders / Senior Unsecured

shareholders
Subordinated

Equity

Secured Unsecured
Shareholders
bondholders bondholders

Capital Structure, Seniority Ranking and Recovery

Rates
 Credit Default
Yay! We
received Strict Priority of Claims
full Not always applied in practise!
payment! Alright.
At least we
recovered
some amount Sob!
lostWe
it all!
Sob! We lost
First Lien / Mortgage Not fair!
it all! We shall
Senior Secured fight for
Junior Secured
something!
Amount owed to
bondholders Senior Unsecured

Subordinated

Equity

Secured Unsecured
Shareholders
bondholders bondholders

Capital Structure, Seniority Ranking and Recovery

Rates
 Credit Default
Yeah.
I’d
rather Loss of customers Bankruptcy Proceedings
Amount recovered bear
some Let’s go Loss of key employees
from liquidation loss. for a Mounting legal expense Costly
quick
resolution Take a long time to settle
!

First Lien / Mortgage

Senior Secured

Junior Secured
Amount owed to
bondholders Senior Unsecured

Subordinated

Equity

Secured Unsecured
Shareholders
bondholders bondholders

Capital Structure, Seniority Ranking and Recovery

Rates
 Credit Default
Ok this is
how the
payments
should go!

First Lien / Mortgage

Senior Secured

Junior Secured
Amount owed to
bondholders Senior Unsecured

Subordinated

Equity

Secured Unsecured
Shareholders
bondholders bondholders

Capital Structure, Seniority Ranking and Recovery

Rates