You will be able to explain default, recovery and seniority, and why they decide what you get back.
Kelvin's relationship manager calls about a company bond paying 5% a year, at a time when Singapore Government bonds of a similar term pay about 3%. The company is a name Kelvin has heard of. The manager says the bond is "very stable". Kelvin asks himself one question before anything else: if this company stopped paying, what would I actually get back, and when?
That question is what this module is about. A company bond pays more than a government bond for a reason, and the reason is what happens when things go wrong.
A default happens when a borrower fails to keep a promise in its bond terms. The obvious case is a missed coupon or a missed repayment at maturity. But the terms also contain other promises, called covenants, such as keeping debt below a set level or publishing accounts on time. Breaking one of those can also count as a default, even if every payment so far has arrived.
After a default, the company and its lenders usually try a restructuring first: they renegotiate the terms so the company pays less, pays later or hands over shares in place of some of the debt. When no deal can be reached, the company may go into liquidation, where its assets are sold off and the proceeds divided among the people it owes.
Either path takes time, and years is more common than months. During that time you usually receive nothing, and your bond, if you can sell it at all, trades far below face value.
What bondholders end up with after a default is called the recovery. It is almost never the full face value. It depends on what the company's assets are worth when sold, how much it owes, and where your bond ranks in the queue.
Here is a made-up example. A company fails owing S$110 million: S$40 million to its bank on a loan secured against its buildings, S$50 million to holders of its senior unsecured bonds, and S$20 million to holders of its subordinated bonds. After costs, its assets raise S$60 million.
The bank is paid first, because its loan was secured. It takes S$40 million and is repaid in full. That leaves S$20 million for the senior bondholders, who are owed S$50 million. They receive 40 cents for every dollar, or 40% of face value. Nothing is left for the subordinated bondholders or the shareholders.
If Kelvin had S$10,000 of the senior bonds, he would get back about S$4,000. And that money might arrive years after the default, with no coupons in between.
The order in that example is the general rule. From first to last, the queue usually runs like this. Senior secured debt is paid first, because it has a claim on specific assets. Senior unsecured debt comes next, which is where most ordinary corporate bonds sit. Subordinated debt is behind that, and many perpetual securities rank here or lower. Shareholders come last of all, after every lender.
Where a bond sits in the queue is called its ranking or seniority, and it is written in the bond's terms. Two bonds from the same company can carry very different risks if one is senior and the other subordinated. You saw in lesson 1.1, A bond is a loan with a fixed timetable, that bondholders are paid before shareholders. Now you can see that lenders also queue among themselves.
In real cases the order can be complicated by legal details, and the courts decide disputes. But the principle holds: the further back you sit, the less you are likely to recover.
Go back to Kelvin's offer. The company bond yields 5%, and a Singapore Government bond of a similar term yields 3%, both made-up figures. The difference, 2 percentage points, is the credit spread.
The spread is what the market charges for the chance that the company does not pay, plus the likely loss if it doesn't, plus a little extra because company bonds can be harder to sell. A bigger spread means the market sees more risk. A spread that suddenly widens means the market has grown more worried about the company.
The spread is not free money. It is payment for a real risk. Over many years and many bonds, it can reward investors who spread their money across many issuers. On a single bond, it can be wiped out by one default, because losing 60% of face value takes many years of an extra 2% to make up.
Kelvin's manager called the bond stable. That might be true. But the spread tells Kelvin the market sees some chance it is not, and the ranking tells him how far back he would stand if that happened. Next you will practise reading that queue on a made-up failed company, and put five kinds of claim in the order they would be paid.
Rank five claims on a made-up failed company, from secured bank loan to ordinary shares, and say who is paid first.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).