Loss Given Default. Issuers have the ability to issue many types of debt under a variety of structures. Not all debt is equal, as some has the right to be paid back before others. Not all lenders have the same risk criteria, as some are willing to take on a little more risk in exchange for a little more return. What this means is that not only does a company or issuer have a credit rating, but so does an individual debt issue or issuance. In order to quantify the risk in a specific issuance, we need to understand the following factors: the seniority, or ranking of the debt within the capital structure. The strength of the collateral, or the loan-to-value ratio. And what about unsecured loans, loans that are not secured by any assets are collateral? Covenants, which give lenders a way to come back to the table early and possibly restructure the loan. The amount of loan relative to other debt in the capital structure. Structure becomes important because as the percentage of a loan package that is unsecured increases, the more difficult it is to syndicate. Presence of financial sponsors in leverage lending. Quality of the sponsor speaks for the deal, track record of a sponsor and stepping up with more equity is also critical. If you are holding secure debt, which is also typically senior, you're more likely to be paid in the event of a liquidation of a company. However, in terms of the ranking of stakeholders in a company, there is a legal precedent. Taxes always get paid first, followed by a liquidator's expenses. Next would be the senior secured debt holders, followed by the senior unsecured debt holders. Subordinated debt comes next. Junior debt comes after that. Any preference, equity, or preferred stock, followed by the common equity. One complication is when we come to things like trade payables or accounts payable, which are essentially short-term credit extended by a company to finance operating expenses. This is an example of what is called a floating charge, meaning that the credit is not tied to a specific asset. All secured or fixed charged debt, meaning tied to an asset, must be paid back before trade creditors are paid. Pari passu is a term that you'll hear often. It means that all debt holders within the same creditor class are treated equally, i.e. repaid at the same time and proportionally the same. Now, in some countries, fixed charge creditors, which would be banks making secured loans tied to assets, have preference over floating to the trade creditors. This is similar to what I was just explaining with the trade payables. The lower the ranking, the higher the loss given default percentage. This table demonstrates why issue ratings drive loss given default, or LGD analysis. Clearly, the more senior and secure the issuance is, which is often the bank debt in a capital structure, the lower the LGD risk is and the higher the issue rating. Vice-versa, for the riskier debt toward the right of the bar chart, this is the debt at the bottom of the capital structure. A properly structured loan and capital structure can mitigate the bank's risk. As you can see on the left side of the chart, structures that have lots of senior and/or secure debt competing for the payouts have lower recovery rates. Well-structured capitalizations that have used more junior and unsecured debt have the higher recovery rates which are shown on the right. In summary, to quantify the LGD, or loss given default, an issue rating is used. The issuer rating is not ignored, but rather is a starting point to then examine the debt instrument. For each issue, a rating is given and a recovery rating is given, estimating the amount expected to be recovered in case of a default.
