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I would like to ask if different debt seniorities ( like senior unsecured bonds and subordinated bonds) have different probability of default?

(Before edited I used debt tiers instead of seniority but I guess that is not the correct terminology)

For example, my initial understanding was that different debt tiers have different priority in a case of a default and when the issuer defaults on a payment it is actually defaulting on all the debt that it has been issued. I was justifying that by assuming that when the company had to pay interest on a date and was unable to (for let's say subordinated bonds) it would actually be unable for all the different seniority of bonds but it would be obliged to pay the most senior ones. Hence issuer defaulting as whole and paying the most senior creditors.

But after reading an article regarding 2014 ISDA CDS definitions I saw that CDS contracts will be triggered based on the seniority of the debt that has been defaulted hence making my initial assumption incorrect and that different seniorities can default separately.

Any insight regarding this would be appreciated!!

Many thanks!!

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    $\begingroup$ Not a bad question, actually. Examples of debt tier: senior secured / first lien; senior unsecured; subordinated. (which in turn could be senior and junior); trade claims; preferred equity; etc. In theory, a company could easily default (not pay dividends) on preferred equity, but not default on bonds. So these two probabilities of default are different. In principle it's possible to default on sub without triggering default on senior, but this is very unlikely. It would be more realistic to assume the same probability of default, but different recoveries (loss given default) $\endgroup$ Feb 3, 2022 at 19:19
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    $\begingroup$ i.e. it's more realistic that sub has the same PD as senior senior and unsecured, but secured debt holders usually get almost 100% back (but perhaps not), senior unsecured get < 100% back (if they could get 100%, why default), and sub gets 0% recovery. Scenarios where someone defaults on sub but not on senior are somewhat theoretical. $\endgroup$ Feb 3, 2022 at 19:22
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    $\begingroup$ It also gets interesting with sovereign debt. Hard currency debt could be local-law and external-law. There have been cases (rare) when countries like Argentina defaulted on external-law dollar debt, but continued paying local-law dollar debt. Converselly, it's common for sovereigns to default on local-law hard currency debt, but continue paying external-law debt. So these have different probablities of default, but are not the same as sub / senior. $\endgroup$ Feb 3, 2022 at 19:24
  • $\begingroup$ Hi Dimitri - many thanks for the detailed responses as always. I guess what puzzles me a bit though is that different CDS contracts will be triggered independently based on the 2014 ISDA methodology which makes me wonder what is actually the case. Unfortunately I can't seem to be able to locate any case where sub contracts triggered before senior ones. $\endgroup$
    – user58873
    Feb 4, 2022 at 18:09
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    $\begingroup$ Hi @DimitriVulis , your comments are again worth a full answer :-) $\endgroup$ Feb 4, 2022 at 22:28

1 Answer 1

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A CDS contract has a "reference entity" (obligor, bond issuer) and a "reference obligation" (the specific bond that needs to default, rather than a tier). Read https://www.isda.org/a/EYEgE/Credit-Derivatives-Disclosure-Annex-July-2021.pdf for lots of very detailed discussions of how CDS works.

But if you look at the single-name consensus CDS curves published by IHS MarkIt here https://www.theice.com/cds/MarkitSingleNames.shtml you will notice they they all have tier SNRFOR (meaning senior unsecured) now. People used to trade CDS referencing subordinated debt. People also used to trade CDS on preferred equity, triggered by not paying dividend. Since 2008 they pretty much don't anymore.

If a credit event happens to the reference entity (for example https://www.cdsdeterminationscommittees.org/cds/europcar-mobility-group-s-a/ ) then if the obligations that defaulted trigger cross-default on the reference obligation, then the protection buyer collects the notional minus the value of the defaulted bond. Everyone does cash settlement these days. If the reference entity has both senior and subordinated debt, then separate auctions may be held for each tier. For example, when Dura Automotive defaulted in 2006, senior was 24, but subordinated was 3.

If someone really wanted physical settlement, the protection buyer could still deliver some bond pari passu with the reference obligation and get the full notional in cash. But if the ref ob is senior, then they can't deliver sub that it not pari passou.

So, if you were to trade a CDS choosing a subordinated bond as the reference obligation (you'd have great difficulty finding someone to trade this with!), then the physical PD is really the same, but the CDS spread would probably be more than for the senior debt of the same reference entity because the recovery would be less. Further, if you observe spreads for both senior and sub (unlikely), and make some assumptions about their recoveries, then you arrive at different risk-neutral PDs.

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