Assume a company has 500K of senior debt trading at 50%, and 250K of sub debt trading at 20%. Therefore, the market value of each is 250K and 40K, respectively. According to BIWS, this also means that creditors expect to recover 50% of the senior debt and 20% of the sub debt.
Why is that so? If ALL senior debt holders have priority in the claims process, why would sub debt holders have any claim when senior debt holders aren't 100% paid out?
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Because the trading value is a indicator of the probability distribution of the outcome. Yes in the bankruptcy the subs would get zero until the seniors are made whole.
Because bankruptcy is expensive and junior debt holders can draw out the process which continues to erode value as long as the company is in limbo, to the detriment of senior lenders. Senior lenders may agree to some minor value concessions to get junior creditors out of the way.
You're also getting a coupon along the way. If the sub debt has a 10% coupon and you think the company has two years of runway, there's your 20c. And you're left with a free option on whatever the sub debt may get in a restructuring.
we have a winner
we have a loser
I wouldn't say the probability distribution comment was incorrect. Obviously, subordinated debt takes on characteristics of out-of-the-money equity in volatile industries. There are plenty of situations, particularly in energy, where firm value volatility is so high that unsecureds will trade at 20/100 while second liens are at 50/100 even when a default seems imminent.
Reality is that if these companies go tits up both the 2L and unsecureds would have been primed by first lien on the way to the court house...both junior tranches likely will realize minimal to no recovery.
They trade at 20 (if they even trade at all) because of coupons, difficulty in shorting, par buyers willing to hang on/unwilling to crystallize loss, etc...
If you're paying $20 because (for example) you think there's a 40% chance they're worth $60 and a 60% chance they're worth $0, you're an idiot.
While I would agree that most sectors have stable firm value estimates, there are two situations where probability distribution is valid: sectors with liquid futures curves and litigation plays where recovery estimates are subject to truncation.
In energy you can use implied volatility from the futures curve to derive probability weighted commodity prices. From this you can calculate expected recoveries of each tranche using market based price forecasts. To say that a company with extensive out of the money reserves is worthless...well I'd buy your bonds all day. I would agree that the "runway" is important but not for the reason you listed (coupon payments). Since these subordinated securities trade like options, value is increased when the "runway" is extended beyond current market estimates.
With regards to your second point, how then do you think Elliot, Aurelius or any litigation-heavy investment firm approaches investing? If you are buying unsecured bonds hoping to use precedent set in one jurisdiction (venue listed in indenture) when the company could claim its operations are headquartered in another...well there are exogenous forces you need to account for in determining at what price to buy. Another example is the risk of expropriation or payment refusal in the case of sovereigns.
Blah blah blah blah jargon jargon jargon jargon...We were speaking in generalities.
I'm obviously an idiot since I like to give simple answers to simple questions.
OP: "Why did the chicken cross the road?"
Me: "To get to the other side."
You: "Well actually, if this was a Rhode Island Heritage Red Chicken, and it's the second week of September with Earth and Neptune at their apoapsis to the Sun, and if their OCA genes have a dominant allele, then it is actually predisposed to cross that road."
Thanks everyone. Another question - assuming a company issues 100K of senior secured debt, would the change in market value over time of the collateral impact the market value of the debt?
Might be a dumb question but here's my thought process. Assuming a 10-year note valued at 100K was secured to a building in 2000. By 2006, the market value of the building has increased 200% since issuance. What would happen to the market value of the note?
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