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A little-remarked-upon feature of Moody's and Standard & Poor's bond rating systems is the fact that a given rating can apply to issues with quite different estimated probabilities of default. For instance, S&P uses its B+ rating not only for senior issues of companies with default probabilities in the high single-B range, but also for subordinated issues of companies with default probabilities in the mid-double-B range.
Recognizing that difficulties may arise when ratings do double duty, Moody's compiles its default rate statistics on a senior-equivalent basis, rather than grouping issues according to their actual ratings. With few other exceptions, however, research on credit experience and on the relationship between ratings and yields lumps senior B1 issues with subordinated B1 issues, senior BB- issues with subordinated BB- issues and so forth.
As we shall demonstrate, failure to distinguish between like-rated bonds of different priorities in the capital structure can foster misperceptions about the relationship between agency ratings and bond pricing. In particular, our informal survey of practitioners discloses a widespread belief that a senior bond ought to yield less than a like-rated subordinated bond. In fact, we show the opposite to be true, both in theory and in practice. We also find that the relative premium on senior debt should and does increase as ratings decrease. Finally, we offer a possible explanation for the paradox of how the market seems to arrive by an incorrect line of reasoning at the correct relative valuation of like-rated senior and subordinated bonds. I. THE TRADE-OFF BETWEEN DEFAULT PROBABILITY AND EXPECTED RECOVERY
To analyze the relationship between equivalently rated senior and subordinated bonds, we first consider two of the most important dimensions of bond valuation, namely, probability of default and severity of default.1 Note that Moody's attempts, just as Standard & Poor's does, to reflect both of these aspects of risk on a single letter-grade scale. For example, a Ba3 rating on a subordinated bond indicates not only a measurable probability that default will occur, but also the fact that the subordinated holder has a lower standing in bankruptcy than a senior holder. See Exhibit 1 for a comparison of the Moody's and Standard & Poor's rating scales.
Let us imagine, for a moment, a world in which companies...