Credit · C1 · 8 min
The credit universe and the capital structure
Line up who a company owes, in the order they get paid, and work out what each lender gets back if it fails.
In the news: “Bondholders lose half their money while the banks are repaid in full”: the order of payment when a company fails.
The essentials
- Credit
- Lending to borrowers who might not pay you back. Bonds from the safest companies are ; riskier ones are and pay more interest for the bigger chance of default.
- The capital structure
- Every claim on a company, in the order it is paid in a default: first-lien loans, second-lien loans, senior bonds, subordinated bonds, preferred shares, then ordinary shares. The higher a claim, the less interest it pays.
- Seniority and security
- is a claim’s place in the queue; is a claim on specific assets, like a mortgage on a house. Loans are usually both, which is why they tend to recover more than bonds.
- Recovery and the fulcrum
- Value is paid down the stack until it runs out. A company worth £500m repays a £300m loan in full, a of 100%, and £400m of senior bonds 50%: they are the . Lower layers get nothing.
- Structural subordination
- Lenders to a holding company are paid only after every creditor of the operating company beneath it, because the holding company owns just its shares. Guarantees from the subsidiaries close the gap.
Recovery of one layer
Recovery = min(claim, value left) ÷ claim
- claim
- what the layer is owed
- value left
- what the company is worth after every layer above has been paid in full
How it works
1. Lending to a company
Lend a friend £100 and you care about one thing: will you get it back? Lending to a company is the same. Companies borrow from banks and by selling bonds to investors, and credit is the business of lending to borrowers who might not pay you back.
2. Safer and riskier borrowers
Some companies are very likely to repay; others less so. Bonds from the safest companies are called . Bonds from riskier ones are : they pay more interest to make up for the bigger chance of not being repaid.
3. Who gets paid first
If a company fails, it can’t pay everyone in full, so its lenders are paid in a set order: their . Bank loans usually come first, then bonds, and the shareholders, who own the company, come last. Loans are often : the lender has a claim on particular assets, like a mortgage on a house.
4. The stack
List every claim from first paid to last and you have the : first-lien loans (first claim on the assets), second-lien loans, senior bonds, subordinated bonds (which agree to be paid after the senior ones), preferred shares, then ordinary shares. The higher a claim sits, the safer it is, so the less interest it pays.
5. Pouring value down the stack
Say a failed company is worth £100m as a going business, its , and owes £60m of loans and £80m of bonds. The loans are paid first, all £60m. That leaves £40m for £80m of bonds: 50p in the pound. The share a lender gets back is its , here 100% for the loans and 50% for the bonds.
6. The fulcrum
The layer where the money runs out, the bonds in that example, is the . Everything above it is repaid in full; everything below gets nothing. Because the fulcrum is only partly repaid, its holders usually swap their claim for ownership of the restructured company.
7. Parent and subsidiary
Big groups often borrow at two levels. The operating company owns the factories and earns the money; the holding company above it only owns its shares. The operating company’s lenders are paid from its assets first, and the holding company’s lenders get only what is left. That is .
Worked example
A retailer restructures. The business is worth £500m. It owes a £300m first-lien loan, £400m of senior bonds and £100m of subordinated notes.
- Start with £500m of value.
- The loan is paid first: all £300m. Recovery 100%, leaving £200m.
- The senior bonds are owed £400m and get the £200m left. Recovery 50%.
- Nothing is left: the subordinated notes and the shares get 0%.
Loan 100%, senior bonds 50%, subordinated notes 0%: the senior bonds are the fulcrum.
Check yourself
7 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Walk me through a company’s capital structure from top to bottom.
Why do loans usually recover more than bonds?
What’s structural subordination?
Remember
Recovery = value left for the layer ÷ its claim
Value runs down the stack from the top: the layer where it runs out is the fulcrum, and everything below it gets little or nothing.