Bond prices in a debt priority structure with absolute priority rule deviation

Abstract

We study the value of senior and junior bonds with random default and absolute priority rule violation and propose a simple approach to value risky bonds with varying parameters for the violation. Recognizing the sources of violation from equity contribution and value loss from challenges by junior bonds, we specify sharing rules among various claimants to the firm value and obtain the credit spreads of both senior and junior bonds from simulation. We find that the impact of one parameter on credit spreads depends on other parameters and those other parameters have to be considered simultaneously to price corporate bonds.