CFA Level II ExamFixed IncomeEasy
A financial institution is evaluating the credit risk of two corporate bonds, Bond A and Bond B. Bond A is a senior unsecured bond, while Bond B is a subordinated unsecured bond. Both bonds are issued by the same company and have similar maturities. In the event of the company's bankruptcy and liquidation, which of the following statements regarding the recovery rates is most accurate?
- ABoth bonds will have similar recovery rates as they are unsecured.
- BBond B will likely have a higher recovery rate than Bond A due to its subordinated status.
- CBond A will likely have a lower recovery rate than Bond B due to its senior status.
- DBond A will likely have a higher recovery rate than Bond B.
Show answer & explanationAnswer & explanation
Correct answer: D. Bond A will likely have a higher recovery rate than Bond B.
Senior debt has a higher priority in receiving payments in the event of default or bankruptcy compared to subordinated debt. Therefore, senior unsecured bonds generally have higher recovery rates than subordinated unsecured bonds from the same issuer.
Why the other options are wrong
- A. The seniority structure creates a significant difference in recovery rates, even if both are unsecured.
- B. Subordinated status implies lower, not higher, recovery priority.
- C. Senior status implies higher, not lower, recovery priority.
Debt Seniority & Recovery
Debt seniority dictates the order in which creditors are paid in the event of issuer default or bankruptcy.
- Senior debt has higher priority than subordinated debt.
- Higher priority generally leads to higher recovery rates.
- Secured debt generally has higher priority than unsecured debt within the same seniority class.
Memory trick: Seniors get the first slice, subs get the crumbs.