Vive La Petite Difference - Debt Rating Policy and Yield Differentials between Senior and Subordinated Debt

Abstract

Corporations seem to issue much more senior than subordinated debt and ratings agencies seem to treat these two types of bonds very differently. We document and explore these differences between senior and subordinated debt. Unlike previous work which focused on rating changes, this paper considers bond ratings at issue. Agencies such as Moody's or S&P rate subordinated bonds by notching them down from senior bonds. We document the market pricing of both senior and subordinated issues. If notching policies were done properly, then we should find that all equally rated bonds should be priced equally (same yield). However, we find that the market systematically prices differently bonds of identical ratings but different seniority. Specifically, we find that yields of speculative senior bonds are higher than the yields of similarly rated subordinated bonds. The sign reverses in most cases for investment grade issues. We provide a conceptual model based upon market frictions which incorporates all our empirical findings.