The fundamental thesis governing credit risk for bond holders relative to loan holders is that the latter is advantaged by the seniority and secured position in the issuer’s capital stack. As our Chart of the Week shows, these two elements work together to give loan investors the best chance for the highest recovery in case of a default.
All things being equal, the weaker position held by bonds is offset by the higher coupons of those instruments. However, as we discussed in the first installment of our special series [link], supply/demand technicals often play a larger role in relative yields than structural fundamentals.
Another factor to consider besides seniority is the type of cushion below you. Having unsecured and truly subordinated debt, along with the sponsor’s cash equity, under your senior secured loan provides additional capital to protect you in a liquidation.
S&P LCD data bears this out. For facilities with a greater than 50% capital cushion below them, the average discounted recovery is 85%. When the cushion drops below 50%, the recovery also drops, down to 50%.