SEARCH FOR YIELDS Issue 8, November 28th
Secured/Unsecured, Senior/Subordinate debt
The difference between secured vs unsecured bonds is the fact that the former is backed by assets while the latter is not. In the scenario where the company that is issuing these bonds goes bankrupt and defaults on their payments to its shareholders, the repayment of the owed principal amount, as well as interest, is not guaranteed to the shareholders. This is because there is no asset or future revenue stream that can serve as collateral. Hence, the bond is 'unsecured'.
The difference between subordinated debt and senior debt is the priority in which a firm in bankruptcy pays the debt claims. If a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation, the senior debt is paid back before the subordinated debt. Once the senior debt is completely paid back, the company then repays the subordinated debt. Senior debt is often secured.
When a company declares bankruptcy, usually nothing is available for distribution to bond holders of all classes
A company declares bankruptcy when it has no funds to both run the firm and pay its creditors. In this case, it goes through a long legal process where the creditors sell the assets, if there are any assets left of value and then distribute the proceeds among themselves. Normally, bankruptcy happens on either complete mismanagement or due to the business being completely disrupted. Hence, assets if any are usually written down sharply in value or are completely worthless. Basically, lenders or bond holders get almost nothing and that too after many years.
Cash flows are the most important factor for bond investors
When a company borrower, it has to generate enough revenues to service the debt. Even if the company is not able to generate enough revenues, infusion of funds by promoters is equivalent to cash flows for servicing the debt. Bond investors always have to ask themselves if the company can generate sustainable cash flows to service debt or if the promoters are strong enough to capitalize the company. In such cases, if answer is positive, investing in higher yielding unsecured or subordinate bonds is more profitable.
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The Lakshmi Vilas Bank (LVB) has issued 3 tranches of unsecured non-convertible redeemable fully paid-up Basel III compliant tier 2 bonds of worth Rs. 3.18 billion. On 26th November 2020, RBI mentioned in a notification that LVB's Basel III compliant tier 2 bonds will be written down before the amalgamation process of the Lakshmi Vilas Bank with DBS Bank. This show the risk in investing in subordinate bonds of banks that have weak fundamentals.
