Senior and Subordinated Issues, Bond Ratings and the Market Price of Debt.

Kose John* New York University

S. Abraham Ravid** Rutgers University

Natalia Reisel*** Southern Methodist University

Abstract
Rating agencies such as Moodys or S&P rate subordinated bonds by notching them down from senior bonds. If notching were accurate, then we should find that all equally rated bonds are priced the same (same yield), perhaps with some random errors. However, we find that the market systematically prices differentially 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. We provide a conceptual model based upon market frictions which incorporates these findings and the finding that highly rated firms issue very few subordinated bonds.

JEL classification codes: G2, G23 Keywords: rating process, subordinated debt, senior debt, notching policy ___________________________________________________________________________ *Department of Finance, Stern School of Business, New York University, 44 W. 4th St. NY, NY 10012. Phone: (212) 998-0337. Fax : (212) 995-4233. Email: kjohn@stern.nyu.edu (Corresponding author). ** Department of Finance and Economics, Rutgers Business School, 180 University Av. Newark, NJ 07102 *** Department of Finance, Southern Methodist University, 6212 Bishop Blvd. Dallas, TX 75275

1. Introduction
This paper considers the causes and consequences of the mechanics of the bond rating process. We find systematic yield differentials of bonds within the same rating category. In particular, subordinated issues are priced too high (the yield is too low) for non-investment grade issues, and the reverse is true for investment grade bonds. This bias remains after we account for issue and firm characteristics. We are able to relate this bias to a notching rule of thumb that is used to rate subordinated debt. In a friction-less world, companies should be indifferent between issuing debt of various seniority levels, since all issues will be priced properly in the market. In the real world, frictions may make one type of issue more beneficial than another. In this paper, we are not looking for the optimal seniority level1 but we find evidence consistent with a Pareto inferior equilibrium, in which bonds are not accurately rated, and issuers shun such bonds since they impose a burden of research costs on buyers. One of problems facing researchers in this area has been the fact that most bond trading is done by institutional investors, and, until recently, data had been scarce. However, in recent years a few data bases have been created, and we are using one of them for our work. Our analysis has more than just academic import. It may inform the current policy debate regarding regulatory oversight of rating agencies, an issue that has gained prominence in the wake of the Enron scandal (see Wiggins, Financial Times, 2004)2.
1

For theory papers discussing seniority see for example, Diamond (1993) and Park (2000). A well known empirical paper is Barclay and Smith (1995) See Cantor and Packer (1995) for uses of ratings in regulations. Additionally, in June 1999 and January 2001 The Bank for International Settlements proposed to determine banks minimal capital requirements using agency ratings.
2

The rest of the paper is organized into several sections. The next section is concerned with related work. We proceed to discuss the institutional setting in section 3. In Section 4, we describe the data. In section 5 we present the results. Section 6 provides a conceptual model that explains the empirical findings and concludes.

2. Related Work
Much of the literature on debt ratings is concerned with the question of whether the rating agencies predict or follow the market. This strand of work can be traced back to Weinstein (1977), who found no bond market reaction to rating changes. However, more recent studies report significant bond and stock market reactions to rating adjustments (e.g. Hand, Holthusen, and Leftwich (1992), Goh and Ederington (1993,1998), Kliger and Sarig (2000)). Results are especially pronounced for rating downgrades. Moreover, Dichev and Piotroski (2001) find negative abnormal returns in the first year following downgrades, which they attribute to underreaction to downgrade announcements. Ederington, Goh, and Nelson (1996) consider a different issue, and find that stock analysts tend to revise their earnings forecast following rating changes. Although this is consistent with most recent work suggesting that rating changes do provide information, Ederington, Goh, and Nelson (1996) note that rating changes are partially a response to information that has already been incorporated into prices. Hull et al. (2004) and Norden and Weber (2004) reach similar conclusions in the context of the credit default swap market. Other work (see Altman and Rijken (2004)) documents a relatively slow adjustment of ratings to information. Only when a threshold is reached, do agencies take action. This is broadly consistent with our findings, however, the question of the optimality of these procedures remains open. A few recent papers have considered more carefully some of the outcomes of the rating process. Loffler (2004) ponders a parallel question to the one we are looking at, namely, should one look at market based or agency based credit risk measures in forming portfolio governance

rules. Butler and Rodgers (2003) provide an interesting take on bond ratings, showing that high fees paid by companies tend to mitigate the effect of publicly observable variables on ratings. High fees are interpreted as indicating a closer relationship between the issuer and the rating agency, and the lesser use of public information is interpreted as reliance on softer information.

Perhaps closer to our line of work, John, Lynch, and Puri (2003) find that secured debt has higher yield than unsecured debt, even after controlling for bond ratings. This is interpreted as rating agencies failure to recognize agency problems between managers and bondholders3. Our paper extends this literature. The next section provides the necessary background and institutional framework of the rating process.

3. The rating process of senior and subordinated debt

Companies can choose the priority level of the debt they issue, subject to covenants (see Reisel, 2005, Wei, 2005). Naturally, priorities matter only if a firm is insolvent. If the firm pays all its obligations as scheduled, then the order of seniority is not important. Ratings agencies, such as Standard & Poors Corporation (S&P), Moodys Investors Service (Moodys) or Fitch, provide information about the quality of debt issues. Quality can have at least two, interrelated meanings. First, it reflects the probability of default, which is related to or calculated by financial ratios such as debt/equity, interest coverage, current ratio; industry characteristics; management; variance in cash flows, etc (see Altman (1977 and later) for work that has become the
Baker et al. (2003) suggest that credit spreads as well as other bond market conditions may be important for the timing of debt issues.
3

industry standard in that respect). Second, quality should reflect the rate of recovery, once default occurs. This latter characteristic is based on the language of the indenture

agreements, and on the amount of assets available to holders of the various classes of securities. The rate of recovery also depends on the marketability of the issuers assets (see, for example, Altman (2004)). As it turns out, these distinctions will have interesting implications for the interpretation of our results. 4 We should note that if a company defaults on one issue, typically all its debt becomes due immediately. Thus, the probability of default for all debt issues of a company is usually equal. However, recovery rates may differ across issues. Moodys reports that the average recovery for senior unsecured bonds is $44.9 for each $100 of investment; whereas for senior subordinated bonds it is $39.1, and for subordinated bonds it is only $32.0 (Moodys Investors Services, 2005). Fitch compilation suggests that the average recovery rates might be somewhat lower: about 35% for senior unsecured bonds and 17% for subordinated senior and junior bonds (Fitch IBCA, 2001).5 Altman reports that the median recovery rate for senior secured bonds, based on a comprehensive sample of issues between 1978 and 2004 is $0.5351 for $1(mean $0.5271). It is only $0.4254 (mean $0.3534) for senior unsecured debt vs. about $0.3191 (mean $0.3013) for senior subordinated and somewhat less for subordinated issues (see Altman High Yield report, November 2004, figure 11)6. Altman and Eberhart

In appendix E we provide institutional background of the rating agencies and compare the various services. Fitch calculations are based on data from 1997 to 2000. Moodys does not report the time frame for the calculations. So, to some extent, the differences may be explained by the time period covered.
6 5

We provide an example using Moodys recovery rate numbers later on in the paper.

(1994) also find that, on average, higher seniority is associated with higher payoffs in the case of bankruptcy. Thus, it certainly makes sense to rate subordinated issues weakly lower. The question is how exactly it should be done. Ratings are costly. There are costs associated with rating the firm and additional costs to rate each subsequent bond issue. Once the firm is rated and the probability of default is determined, then the most important remaining question for each bond issue is the probability of recovery in case of default. However, forecasting individual recovery rates is a very costly operation. Our focus in this paper is on the relative evaluation of senior vs. subordinated debt. In particular, we highlight the institutional practice known as notching, which was adopted both by S&P and by Moodys. S&P notches secured debt up from the senior company rating and notches subordinated debt down. The rationale is that the notching policy primarily intends to reflect the relative recovery prospects of different instruments issued by the same issuer (S&Ps Corporation, 2001). Moodys suggests that the notching policy is intended to result in expected loss rates of similarly rated securities that are roughly the same, regardless of whether the bonds are secured, unsecured or subordinated claims on individual issues. Yet, in the same publication (November 2000), Moodys also suggests that absent any other information, subordinated debt is generally rated one notch below its senior unsecured rating. We will show later that the notching practice is much more common than one would expect from a presentation that suggests that other information is taken into account as well.

Moodys may also notch up secured debt. This upward notching is most likely to occur for the bank debt of the speculative grade companies.7 Below we explore the consequences of this notching system, which affects billions of dollars in debt issues.

4. Data Description
Our data comes from the Fixed Investment Securities Database (FISD). This database contains a wide range of information about corporate bond issues, including issuer, offering data, maturity data, coupon type, offering yield to maturity, seniority level, ratings, and bond characteristics such as convertibility, putability, and callability. We consider fixed rate dollar denominated bonds of industrial, financial, and utility companies for which yield data is available. Only issues rated by S&P on the offering date were included initially but we repeat the analysis for Moodys rating categories as well. We also exclude putable, convertible and senior secured bonds. 8 For the selected issues, we calculate treasury spreads. The data on yields of government bonds and notes is obtained from Global Financial Data, Inc., which provides information on a daily basis for all maturities except 15 and 25 years. The data for 15-year and 25year maturity government bonds are provided on a monthly basis. We exclude all issues

Moodys provide statistics on the differences in ratings between senior unsecured bond and bank debt: for 45% of the issuers the differences in ratings are 0; for 37% the bank debt is rated one notch higher; for 14% - two notches higher, and for 1% - three notches higher. Interestingly, in 2% of the cases, the senior unsecured bond is actually rated one notch higher (Moodys Investors Services, 1999a). We focus on senior unsecured bonds rather than on the combination of senior unsecured and secured bonds. The reason is that secured bonds can be potentially notched up introducing bias into the senior bond category. However, we repeat the analysis combining all senior debt: secured and unsecured. The results dont change significantly. Only results for senior verses subordinated debt are presented in this paper.
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with negative T-spreads.9 This procedure produces a sample of 11,180 observations. The sample covers time period from 1982 to 2001. Appendix B provides summary statistics for various variables. To integrate financial information and company ratings for the bond issuers, we merge the Fixed Investment Securities database with COMPUSTAT database based on the issuers CUSIP number. We use quarterly data and thus are able to match 7,631 bond issues.

5. Results

4.1 The Yield differential between senior and subordinated bonds within the same bond rating category

We start with the simplest of tests, a means comparison, which identifies the patterns that exist in the data. We proceed to verify our findings using regression analysis. Later we perform concept and robustness checks which confirm that the patterns we find are not the result of peculiarities in the data set. We also present robustness checks showing that our results hold also for Moodys ratings. Means comparisons We first consider the prevalence of the various types of debt and then look at the rating of debt with different levels of seniority. Table 1 shows a striking difference between the number of senior and subordinated issues. Investment grade debt is mostly

Although zero treasury spreads may be possible for highly rated debt, they are very unlikely for low-rated bonds. Thus, negative Tbill-spreads are likely to be due to the mistakes in the database.

senior (we do not expect too many subordinated AAA issues, of course, but there are relatively few A or A- rated subordinated issues as well). On the other hand, for non investment grade, the ratio of subordinated to senior issues almost reverses. 10 However, the most interesting finding is that the mean yields of the senior unsecured and of subordinated debt within each rating category are significantly different. Mean treasury spreads are higher for subordinated bonds compared to senior bonds in the same rating category for most investment grade issues (for example, AA senior bonds trade at a yield differential from comparable treasuries of 0.67, whereas subordinated debt trades at 0.89). Most of these differences are statistically significant. For ratings of B+ and lower, the direction of the yield differential is reversed. Senior debt trades at a higher yield than junior debt of the same rating category. We should note that often, the yield of speculative rated bonds is high enough to be comparable to the yield of senior bonds of a higher rating category. Our results are confirmed using medians comparisons as well (Table1. Panel B). If notching were done accurately, there should be no systematic differences in yields between senior and subordinated bonds of the same rating category. However, the means comparison results seem to indicate systematic biases, possibly as a result of the notching policy employed. The data is consistent with over-notching of speculative rated bonds and under-notching of investment rated bonds.

In fact, some industry insiders lament the disappearance of subordinated issues. The FISD data set does not contain all debt issues, but it is a large subset and there is not obvious bias in the distribution of seniority across issues.

10

Regression analysis Next we present regression analysis of treasury spreads on seniority. In our tests, we control for all observable bond characteristics and try to see whether the notching effect remains. We control for coupon and bond maturity11. Elton, Gruber, Agrawal, and Mann (2001) argue that taxes explain a substantial portion of treasury spreads. The spreads of the high coupon bonds should be wider than that of low coupon bonds. Maturity is another factor that may influence bond yield. Following John, Lynch, and Puri (2003), we add two dummy variables: one takes the value of one if bond maturity is less than 5 years and zero otherwise; another takes the value of one if bond maturity is more then 15 years and zero otherwise. To control for changes in macroeconomic conditions over time, we include the benchmark Treasury rate, differences between the ten and two-year Treasury rates, and year dummy variables. The first variable describes the level and the second the slope of the term structure. To capture cross-sectional differences in corporate bond liquidity, we add issue size. Results of the regressions are presented in Table 2. Table 2 omits the coefficients of the rating dummies, but they are consistent with those reported in earlier studies (see, for example, John, Lynch, and Puri (2003)) and with the means comparisons results of this section. Bond-rating coefficients are highly significant and are higher for higher rating categories. The parameter estimate of the seniority level dummy variable is positive and statistically significant at the 1% level. In other words, on average, seniority increases the yield by 8 basis points after controlling for bond ratings. However, we do not expect the effect of the notching policy to be homogeneous across different rating

10

categories (as suggested by the means comparison results). We thus repeat the analysis for each rating category. The results of this analysis are presented in Table 3. Consistent with the univariate results, seniority level has a significant effect on bond yields within each rating category. The effects are different for different rating categories. Top-rated senior bonds, A+ and higher, have lower yields than similarly rated subordinated bonds. For some lower rated bonds, we find that yields of subordinated bonds are lower than those of senior bonds, and the differences are statistically significant at conventional levels. For example, the yield of B+ senior bonds is 56 basis points higher than the yield of equally rated subordinated bonds. We should note that other bond characteristics variables are often statistically significant in determining bond yields. Maturity, callabitity, and coupon significantly affect bond yields after controlling for bond ratings. However, whereas rating agencies can argue that callability or coupon may affect yields but not what happens upon default, seniority is intimately related to bankruptcy, and as such should be properly represented in bond ratings. The next section will consider whether the patterns we have found are a result of a conceptual mis-specification, namely, whether there is indeed evidence of notching in the data, and whether bonds of the same company are rationally rated, that is, whether the same companys subordinated issues have higher yields. We find that the answer to both questions is yes, which increases our confidence in the findings presented so far.

11

See Ravid (1996) for a survey of studies analyzing the effects of bond maturity structure.

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6. CONCEPT AND ROBUSTNESS CHECKS Concept check 1: Notching pattern So far, we have compared the yields of senior and subordinated bonds, implicitly taking notching into account, but without actually identifying the notching pattern for the bonds in the sample. In this section, we attempt to establish whether subordinated bonds are actually notched down and by how much. We use two approaches to identifying notched bonds. First, we rely on information available in the FISD. For each company in the database, we match senior and subordinated bonds to determine the differences in ratings. This approach to identifying notched bonds produces a substantial loss in the number of observations. Additionally, we use information provided by COMPUSTAT to identify the notching pattern in the database. In that case, we use the quarterly S&P Long-Term Domestic Issuer Credit Rating as our senior rating.1213 S&P describes the correspondence between company rating and senior bond rating, stating further that their policy is to notch subordinated debt down from the company rating (S&Ps Corporation, 2001). The results are presented in Table 4. A majority of subordinated bonds are notched down: bonds rated BB+ and higher are usually graded one notch lower than senior bonds of the same company, while BB- bonds and below are rated two notches down. In total, 84.6% of BB+ and higher rated bonds are notched down. 82.7% of the
Although some rating differentiation under this approach may be simply due to the rating changes within a quarter, we estimate that the bias is not sufficient to change the identified pattern.
13 12

On September 1, 1998 S&P changed somewhat the definition of a company rating from a specific reference to senior debt to overall credit worthiness. However, no specific changes in ratings seem to have taken place then.

12

BB+ bonds are rated one notch down only. On the other hand, whereas 98.2% of the bonds rated BB- and below are notched down, the vast majority of them, (94.2% of the total) are rated two notches down relative to senior bonds. It also seems that the absence of subordinated bonds in BB rating category may be attributed to the switch from one notch down policy to two notches down policy. The findings of this section document a wide-spread notching pattern. The vast majority of bonds are notched in a very predictable way, namely, investment grade subordinated bonds are typically rated one notch down relative to the senior bonds, whereas speculative-rated subordinated bonds are typically notched down twice. As a result of this policy, the same rating may be assigned to bond issues that differ with respect to the probability of default and with respect to the recovery rate. For example, a rating of B- , (using S&P notation), may be assigned to the senior bond issue of a company with a rating of B- as well as to the subordinated issue of a company with the rating of B+ . It seems that the attempt to create loss rates that are roughly the same for all equally rated bonds is rather lame, and that an arbitrary policy is followed in the vast majority of cases14. The next sub-section further supports this claim by addressing the question of how investors price the differences in recovery rates of bond issues with identical probabilities of default.

14

However, in its 2005 guidelines (Moodys 2005), Moodys seems to suggest there are current notching rules (ibid. p.3) and refers to a table that corresponds almost precisely to our empirically derived table.

13

Concept check 2: Senior versus Subordinated bond yields controlling for company ratings This section compares yields of senior and subordinated bonds after controlling for company ratings rather than bond rating categories. Company ratings essentially capture the probability of default but do not capture the differences in recovery rates of bond issues with various seniority provisions within the company. Controlling for company ratings rather than bond ratings allows one to see how the market prices the differences in recovery rates directly. COMPUSTAT quarterly S&P Long-Term Domestic Issuer Credit Rating is used for the company rating. First, we use all issues for which COMPUSTAT company ratings are available and regress treasury spreads on seniority levels controlling for other bond characteristics and company ratings. As expected, the coefficient of the seniority level variable is negative (subordinated bonds of the same company have a higher yield than senior bonds), and it is statistically significant at the 1% level. All other bond characteristics as well as company ratings also carry a significant explanatory power. Results are presented in Table 5. We then group bonds into homogeneous categories with respect to probability of default using the company ratings. Results for major rating groups are in Table 6.15 Senior bonds have lower yields than subordinated bonds within each major companyrating group. The coefficient of the seniority variable is statistically significant at conventional levels for all company-rating groups but the B group. Investors, as

15

The number of subordinated bonds for some rating categories is too small to allow for more refined groupings. We also had to omit AAA rated bonds and CCC rated bonds, which may account for the different coefficients in tables 5 and 6.

14

expected, place weight on the probability of recovery. As we have seen earlier, this does not seem to be captured properly by the notching policy.

Concept check 3: Expected loss rates To further investigate the aptness of the notching policy employed by rating agencies, we compare loss rates of senior and subordinated bonds for various company rating categories. 16 We use Moodys data on probability of default and recovery rates and consider 1, 5, 10, and 20 year investment horizons. The results are presented in Table 7. The findings support the view that notching policy creates biases. Consider, for example, bonds issued by Ba2 (BB using S&P system) rated company. For a 10-year investment horizon, the expected loss rate for senior bonds is 8.63%, while the same loss for subordinated bonds it is 9.97%, which is quite close. Lets assume now that we were to notch the bonds two notches down from the company rating to B1 (B+ using S&P system). This puts these subordinated bonds in the same bond rating category as senior bonds of B1 (B+ using S&P system) rated company. The expected loss rate for these senor bonds is 31.45%, which is more than 3 times higher. This example suggests that rating subordinated bonds of speculative grade companies two notches down creates a bias. Similar relationships are true for different investment horizons. Naturally, two notches may be appropriate for some bonds, but as we have seen, on average it may not work.

16

This is issuer-level rating using Moodys notation. Moodys also calls this rating estimated senior unsecured rating (see, Moodys Investor Services (2005)).

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Robustness check: The Effect of seniority provisions controlling for Moodys bond ratings To identify whether the positive yield differentiation between senior and subordinated bonds is unique to S&P bond ratings, we repeat the analysis using Moodys ratings. If Moodys correctly assigns ratings based on bond characteristics, then investors may rely on Moodys rather than S&P in valuing bonds. Table 8 repeats the analysis provided in table 2 using Moodys ratings. The effect of the seniority dummy is positive but significant only at the 15% level. This may indicate that Moodys notches bonds more accurately, but the low level of significance may also be the outcome of the different weights on the opposite effects for investment grade and junk bonds. 17 Indeed, the analysis in Table 9 for each Moodys rating category shows the pattern evident in table 3. In particular, the coefficient of the seniority level is negative and often significant for highly rated bonds, and it is positive for most low rated bonds, and highly statistically significant for B1, B2, and B3 rating categories.

6. Interpretations, Policy Implications and Conclusions:

Bond issues of the same company may be assigned to different risk groups as they provide different levels of investment protection. In particular, a senior bond can be regarded as a safer investment relative to a subordinated bond of the same company, as it may provide a higher recovery rate in case of bankruptcy. In this paper, we show that the practice of notching issues down from senior level bonds may create a systematic
17

Butler and Rodgers (2003) point out that in cases of split ratings, Moodys tends to be tougher but oddly, all subordinated debt is rated safer by Moodys (ibid. p.9). This supports our findings in this section.

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bias. Specifically, we find that both major rating agencies seem to over-notch some lowrated bonds, and, to a lesser extent, under-notch investment grade bonds. Another interesting finding is the paucity of subordinated issues, in particular in the case of investment grade debt. A possible market based explanation of these findings follows18. Senior debt issues are most often assigned a company rating, in particular for investment grade debt. In fact, as noted earlier, this is explicitly the policy of both major houses19. Thus, in some sense, rating senior debt is a sunk cost. Junior issues require additional work. However, it seems that instead of expending the resources necessary to evaluate each specific issue, the rating agencies apply a notching policy, as we have documented in the paper20. As a result, buyers realize they need to put in additional effort in order to value a subordinated debt issue. This is a true friction, which discourages the issue of subordinated debt. Even if we assume that everything if fairly priced, then the additional effort the buyer requires is priced, and it lowers the proceeds to the issuing company21. Indeed, we see that highly-rated companies shun subordinated debt and issue mostly senior debt. Non-investment grade companies on the other hand, may face strict covenants and capital constraints, and thus may have to resort to subordinated issues.
18
19

We should note that we assume throughout that the market price reflects the true value of the bonds.

This has not changed over time. Moodys, 2005 suggests that: ..analysts first assign a senior unsecured debt rating to an issuer, and then determine (the other ratings) in the speculative grade sector, the process is similar although the benchmark is the senior implied rating..

Mortensen, in a New York Times article (2005) says: ..rating agencies typically receive the largest fees when they analyze an initial bond issue. After that, a nominal fee is levied, providing something of a disincentive to do in depth, time consuming work
21

20

We are assuming that rating agencies can do the job in a more efficient fashion, once they have rated the senior bonds.

17

Further, since for non-investment grade debt there is a greater likelihood that even the senior level public debt be assigned a different rating than the company rating (in particular if secured or bank debt is involved) then buyers need to expend similar resources for both types of debt and are relatively more likely to buy subordinated issues22. The discussion so far explains why we find very few subordinated, highly rated issues, and suggests a rationale for the notching process employed by the agencies. We can perhaps best explain the source of the notching biases we find if we consider recovery rates and default probabilities. Investors are interested in the expected return on a bond, perhaps, with a risk premium. Therefore, the yields paid by the market, reflecting investors research, are a function of default probabilities as well as recovery rates. For highly rated bonds, (down to A) notching down one level makes practically no difference in default probabilities. For example, the 10 years cumulative default probabilities are 0.55% for AA rated bonds and 0.82% for A rated issues23. However, there may be a significant difference in recovery rates should a default occur between issues with different levels of seniority. Therefore, notching down one level may be insufficient. For lower rated bonds, on the other hand, notching down two levels reflects a huge difference in default probabilities- for example, the cumulative default rate over 10 years for BB rated bonds is under 20% whereas for CCC it is close to 60%. The comparatively more modest difference in recovery rates for various seniority levels of the

22 23

We have confirmed the facts presented in this analysis with industry insiders. All data is from Altmans High Yield Bond report, January 2004.

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same company does not justify this type of downgrade, and thus the market yield on the notched bonds is lower than the yield on similarly rated senior bonds. We can further document this idea if we go back to table 7, which tabulates default rates, recovery rates and expected losses from Moodys data.24 . There are some difficulties in the calculations at the AAA level and similar highly rated bonds, since they rarely default. However, consider for example the 10 year expected loss for A2 (original issue) bonds, which is 0.8%. For subordinated A2 bonds the expected loss is 1.06%. Yet, senior A3 bonds have the same, 0.8% loss rate, so notching down one notch does not properly reflect the expected loss. On the other hand, consider Ba3 rated bonds. The expected 5 year loss rate for senior bonds is 11.27% and for subordinated debt it is 13.02%. However, notching the subordinated bonds down two notches to B2 gets us bonds with a senior expected loss of 20.71%. If we notched down the bond down only one notch, we would get an expected loss rate of 16.75% which is closer to the actual number of 13.02%. We note that we are looking at Moodys data, where biases were found to be less severe. Our paper suggests that proper rating of each issue is needed. However, since we find systematic biases in the rating of subordinated debt, we may want to consider a different notching policy. Since investment grade debt seems to be under-notched and non-investment grade debt seems to be over-notched, we may consider notching investment grade more, and junk bonds less. This means that, for high yield debt, subordinated bonds should all be matched with senior bonds of a higher rating category.

24

The actual story can be somewhat more complicated, as default rates and recovery rates may be cyclical and interdependent- see Altman et al. (2005).

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This may indeed be a better policy. To consider this idea in somewhat more detail, we refer back to table 1. When we implement the new policy, the lowest category subordinated bonds in our sample will be rated B-. According to the rating agencies policies, if the senior bond is rated B, the subordinated bond is rated CCC+. The new suggested policy will increase the rating to B-. Therefore, instead of having senior Bbonds with a yield of 5.46% and junior of 4.61% as we find in table 1, we will now match the 5.46% to 4.88%, lowering the differential from over 1% to 0.56%. In this particular case, not notching at all may be even better. One notch policy will decrease the gap in the B category from 0.61% to approximately 0, and in the B+ category from 0.62% to 0.21%. For investment grade debt we obtain mixed results. However, notching down twice may improve matters in some cases. In the A+ category, for example, the gap (this time, of course, subordinated debt has a higher yield than senior debt) will go down from 0.3% to 0.18%. In the A category, however, notching down will increase the gap somewhat. In the higher rating categories, the differences in probability of bankruptcy are possibly too small for anything to matter. Thus we find some support for the view that although notching may not be the best policy, there still can be better rules. In conclusion, we find systematic yield differentials between bonds of equal rating. We are able to relate these differences to the notching policy employed by rating agencies. These findings, and the paucity of subordinated debt, can be considered within a rational framework of costs and benefits, although we may be able to offer a somewhat better rule of thumb.

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Appendix A. History and background of the Rating Process The historical trail of rating agencies is interesting and illustrates the ideas we present. Credit rating agencies can be traced back to the mercantile credit agencies starting with Louis Tappan in 1837 (Cantor and Packer (1995)). These mercantile agencies rated the ability of merchants to pay. John Moody started rating railroad bonds in 1909, and added utilities and industrials soon afterwards25. Poors, the Standard Statistics Company, and the Fitch Publishing Company followed Moodys in the next few years. S&P was formed by the merger of Poors and the Standard Statistics Company. The title of Poors Register was changed to S&P Register in 1971. Moodys Manual of Corporations was published as early as 1900. That manual had no rating information, but rather a description of the company, its officers, and a summary of its financial position. S&P and Fitchs use letter designations, while Moodys uses a combination of letters and numbers. The agencies started adding + or - in the early 1970s (Ederington and Yawitz, (1994, pp. 13-14)) to refine the gradations. Moodys followed with their 1, 2 or 3 modifiers in 1982. The important point is that the agencies have been changing the gradations they assign, in response to changing market conditions and cost considerations. Although the rating methodologies had been developed separately, market pressure forced the rankings to evolve to the comparable rankings we see today. A large number of studies (including Billingsley et al. (1985)) have compared the rankings produced by the various agencies.

25

Cantor and Packer (1994, page 2) specify 1910, while Ederington and Yawitz (1987, page 234) specify 1914.

21

There is general agreement across agencies that the ratings of the different agencies are equivalent as shown below: Moodys Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C D S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCCCC C D

For many years, bonds with S&P ratings of BBB- and above have been considered investment grade, (i.e., appropriate for investment by regulated investors such as banks), whereas bonds rated BB+ and lower have been considered speculative grade (less formally, junk). This distinction appears to stem from the legal constraints on certain investors, such as savings banks and trusts. Such investors, including commercial banks and insurance companies are restricted to investing only in investment grade securities. The regulations specifying these restrictions also identify which rating organizations can be used. Typically the regulations have language such as nationally recognized rating agencies. Whereas, in principle, ratings should be

22

continuous, in practice, there are differences between investment grade and noninvestment grade bonds, as we find in this study as well. Rating agencies charge the issuers a fee, estimated by Cantor and Packer (1995) to be 2 to 3 basis points per year. This fee structure may lead to a possible conflict of interest. A rating agency, particularly one trying to increase its market share, may implicitly offer higher ratings. This possibility of a conflict of interest is more pronounced if the impact of a rating change is more significant, say, in the case of a change from investment grade to non-investment grade or vice versa. Rating agencies use interviews with management to gain insight into the quality of leadership in the company and other information not available to the public. If the issuer does not want to pay for the rating, the agency must proceed without managements help. However, if management input is not available, the agencies are likely to be more conservative in their rating (Partnoy (1999)).26

26

For more details on credit rating industry structure see White (2001)

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Appendix B. Summary Statistics Panel A. Continuous variables Variable Coupon (%) T-spread (%) Offering Amount Mean 7.26 1.29 141,352.64 Median 6.97 0.84 50,000.00 Std. Dev. 1.54 1.28 252,530.54 N 11,180 11,180 11,180

Panel B. Frequencies for dummy variables Senior Callable 9,908 3,839 (88.62%) (34.34%) Maturity < 5 Maturity >15 3,686 1,444 (32.97%) (12.92%) Financial 6,191 (55.38%) Industrial 1,171 (10.47%)

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29. Loeffler, G., 2004. Ratings vs. Market Based Measures of Default Risk in Portfolio Governance. Journal of Banking and Finance, November, 2715-2746. 30. Moodys Investors service, 2005. Moodys Senior Ratings Algorithm and Estimated Senior Ratings. 31. Moodys Investors service, 2002. Moodys Changes Notching Practices for US Life Insurers, Rating Methodology. 32. Moodys Investors service, 2000. Summary Guidance for Notching Secured Bonds, Subordinated Bonds and Preferred Stocks of Corporate Issuers. 33. Moodys Investors service, 1999. The Evolving Meaning of Moodys Bond Ratings. Rating Methodology. 34. Moodys Investors service, 1999. Moodys Analytical Framework for Speculative Grade Ratings. Rating Methodology. 35. Moodys Investors service. The Function of Ratings in Capital Markets, Special Comments. 36. Moodys Investors service, 2005. Default and Recovery Rates of Corporate Bond Issuers, 1920-2004. Special Comment 37. Mortensen, G, 2005. Wanted: Credit Ratings. Objective Ones, Please. NY Times, Sunday Business, February 6. 38. Norden, L., Weber, M., 2004. Informational efficiency of credit default swap and stock markets: The impact of credit rating announcements. Journal of Banking and Finance 28 (11), 2813-2843. 39. Park, C., 2000. Monitoring and Structure of Debt Contracts. Journal of Finance, 55(5), 2157-95. 40. Perraudin, W., Taylor, A., 2004. On the consistency of ratings and bond market yields. Journal of Banking and Finance 28 (11), 2769-2788. 41. Pinches, G., Singleton, J. C., 1978. The adjustment of stock prices to bond rating changes. Journal of Finance, 33. 42. Portnoy, F., 1999. The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies. Washington University Law Quarterly, 77 (3), 619712. 43. Ravid, S. A., 1996. On Debt Maturity and Other Contractual Provisions. Financial Markets Institutions and Instruments, October.

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44. Reiter, S., Zeibart, D., 1991. Bond yields, ratings, and financial information: Evidence from public utility issues. The Financial Review, 26. 45. Roberts, G., Viscione, J., 1984. The impact of seniority and security covenants on bond yields: A note, Journal of Finance, 39. 46. S&P Corporation, 2001. Risk Management Applications Put New Focus on Rating Criteria. Commentary. 47. Veldkamp, L., 2004. Information Markets and the Co-movement of Asset Prices Unpublished working paper. New York University. 48. Weinstein, M., 1977. The effect of a rating change announcement on bond price. Journal of Financial Economics, 5. 49. White, L., 2001. The Credit Rating Industry: An Industrial Organizational Analysis, Unpublished working paper. New York University 50. Wiggins, J., 2004. Credit Rating Agencies Face Tougher Reporting and Record Keeping Standards. Financial Times, front page, June 7.

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Table 1. Differences in Means/ Medians between senior and subordinated bonds for each S&P bond-rating category The sample consists of bond issued between 1982 and 2001. Panel A. Differences in Means

Rating AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+

Senior Unsecured Mean N 0.4678 704 0.605 45 0.674 227 0.6457 875 0.699 1,527 0.8063 2,228 0.8815 825 1.1309 790 1.2009 830 1.4614 459 2.3243 105 1.7050 823 3.3629 87 4.3055 142 4.6917 141 5.4626 80 6.2846 13

Subordinated
Mean

0.6744 0.4611 0.8858 0.7674 1.009 0.9602 0.8932 1.0244 1.249 1.8256 2.3721 3.3348 3.6837 4.0876 4.6153 4.8816

N 3 1 18 20 30 259 125 43 21 28 84 0 38 92 182 307 17

p-value 0.4249 0.0490 0.1136 <.0001 <.0001 0.7194 0.1404 0.7516 0.0171 0.6876 0.8976 <.0001 <.0001 <.0001 0.0064

Test of equality of variance is conducted. In case, when hypothesis of equality of variance is rejected at least at 5% level, t-values and p-values are presented under assumption of unequal variances. ** The number of subordinated bond issues for some rating categories are too small to make credible conclusions.

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Table 1. Differences in Means/ Medians between senior and subordinated bonds for each S&P bond-rating category (continued) Panel B. Differences in Medians

Rating AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+

Median

Senior Unsecured N 0.326 704 0.62 45 0.59 227 0.55 875 0.61 1527 0.69 2228 0.72 825 0.9765 790 0.9785 830 1.27 459 2.106 105 1.51 823 3.24 87 4.115 142 4.63 141 5.165 80 6.78 13

Subordinated
Median

0.574 0.4611 0.715 0.666 0.979 0.845 0.818 0.9 0.995 1.407 2.475 3.42 3.5375 3.885 4.345 4.915

N 3 1 18 20 30 259 125 43 21 28 84 38 92 182 307 17

p-value 0.2019 0.8803 0.0031 0.0372 0.0001 0.0001 0.0022 0.555 0.2691 0.0632 0.1371 0.6853 0.0001 0.0001 0.0001 0.0152

p-values are reported using Wilcoxon test

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Table 2. Effect on bond yield of bond seniority level after controlling for S&P bond ratings
The sample consists of bond issued between 1982 and 2001. The dependent variable is corporate bond offering yield spread. The regression also includes a set of dummy variables for each

S&P bond rating category that are not reported. Results are corrected for heteroskedasticity and clustering (robust p-values). Robust p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.4639 <.0001 <.0001 <.0001 <.0001

Parameter estimate p-value Intercept 0.62941 <.0001 Senior 0.07509 <.0001 Callable 0.12524 <.0001 Maturity <5 years -0.22648 <.0001 Maturity >15 years 0.14974 <.0001 Coupon 0.44465 <.0001 Ln (offering amount) 0.02463 <.0001 Closest benchmark treasury rate -0.56582 <.0001 10 year 2 year treasury -0.02125 0.0293 Financial (relative to industrial) 0.07814 <.0001 Utilities (relative to industrial -0.10014 <.0001 1980years<1990 0.44748 <.0001 Yeara2000 0.37291 <.0001 Number of observations=11,177 Adjusted R=0.8830

Variable

*The parameter estimates for bond ratings are not presented in the table but the results are consistent with those reported in earlier studies (see, for example, John, Lynch, and Puri (2001)): bond-rating coefficients are highly significant and the coefficient is increasing with increase in rating.

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Table 3. Effect on bond yield of seniority level for each S&P bond-rating category The table below gives parameter estimates of the seniority level dummy variable for each S& P bond-rating category. Dependent variable is corporate bond offering yield spread. Each regression includes a set of control variables presented in Table 2. Results are corrected for heteroskedasticity and clustering.

Rating AA AAA+ A ABBB+ BBB BBBBB+ BBB+ B BCCC+

Parameter estimate of seniority level -0.19008 -0.11378 -0.22626 0.04860 -0.03249 0.01431 -0.02635 -0.01269 0.01025 -0.03274 0.55857 -0.02580 0.21331 0.03679

p-value 0.1257 0.0320 <.0001 0.0301 0.1896 0.1210 0.7152 0.3367 0.6904 0.0839 <.0001 0.1743 0.0296 0.2835

Robust p-value 0.1737 0.0320 <.0001 0.0084 0.1836 0.1150 0.7152 0.3367 0.7399 0.0900 0.0001 0.2200 0.0296 0.1402

N 245 895 1,555 2,487 950 833 851 487 189 125 234 323 387 30

Adjusted R 0.2333 0.5583 0.5360 0.5769 0.8027 0.9916 0.7870 0.9939 0.9844 0.9955 0.3514 0.9818 0.7230 0.9982

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Table 4. Identified notching pattern for each rating category. Number of matched subordinated bonds 1 18 15 19 211 83 33 12 14 73 0 33 69 106 128 11

Rating AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+

Number of equally rated bonds 0 1 1 3 6 2 0 2 2 0 0 0 0 0 5 0

Number of lower rated bonds One notch Two or more down notches down 1 0 17 0 13 1 14 1 199 4 79 2 33 0 9 0 11 1 12 0 0 0 1 32 3 66 3 102 5 118 2 9

Number of higher rated bonds 0 0 0 1 2 0 0 1 0 61* 0 0 0 1 0 0

*The results are driven by the issues of one company

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Table 5: Effect on yield of bond seniority level after controlling for S&P company rating
The sample consists of bond issued between 1982 and 2001. The dependent variable is corporate bond offering yield spread. Company ratings are from Compustat. Results are corrected for

heteroskedasticity and clustering. Parameter p-value estimate Intercept 0.82708 <.0001 Senior -0.28214 <.0001 Callable 0.14416 <.0001 Maturity <5 years -0.20813 <.0001 Maturity >15 years 0.09350 <.0001 Coupon 0.49310 <.0001 Ln (offering amount) 0.03403 <.0001 Closest benchmark treasury rate -0.60560 <.0001 10 year 2 year treasury -0.01071 0.2917 Financial (relative to industrial) 0.04621 0.0002 Utilities (relative to industrial -0.21811 <.0001 Company rating AA 0.10014 <.0001 Company rating A 0.10279 <.0001 Company rating BBB 0.32260 <.0001 Company rating BB 0.92048 <.0001 Company rating B 1.79681 <.0001 Company rating CCC 2.57565 <.0001 1980years<1990 0.29873 <.0001 Yeara2000 0.34792 <.0001 Number of observations=7,631 Adjusted R=0.8764 Variable Robust p-value <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.7497 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001

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Table 6. Effect on yield of bond seniority within S&P company ratings The table below gives parameter estimates of the seniority level dummy variable for each S& P company-rating category. The sample consists of bond issued between 1982 and 2001. Dependent variable is corporate bond offering yield spread. Each regression includes a set of control variables presented in Table 2. Results are corrected for heteroskedasticity and clustering.

Companyrating group RAA RA RBBB RBB RB

Parameter estimate -0.06633 -0.02385 -0.32573 -0.16453 -0.04126

p-value 0.1609 0.3778 0.0001 0.0034 0.6079

Robust p-value 0.3272 0.9319 <.0001 0.0129 0.8367

N 830 3486 1324 1183 253

Adj. R 0.4086 0.4871 0.4625 0.7986 0.7861

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Table 7. Expected loss rates Panel A. Moodys default and recovery rates for various company ratings and seniorities
Default rates* 1 year 0 0 0 0 0 0.03 0.03 0.17 0.12 0.41 0.66 0.62 2.23 3.03 5.93 10.77 22.24 5 years 0.18 0.15 0.28 0.18 0.38 0.68 0.65 1.46 2.11 3.6 6.76 8.82 19.14 25.27 31.24 43.55 60.4 10 years 0.4 0.25 0.67 0.33 0.84 1.69 1.69 2.31 5.49 7.2 12.38 14.66 36.24 47.43 44.48 62.32 78.81 20 years 0.4 1.48 2.84 2.59 2.79 4.77 6.73 6.19 17.94 15.7 27 37.44 53.01 60.7 56.32 70.02 81.46 Recovery rates** Senior unsecured bonds n/a 40.2 40.2 40.2 52.7 52.7 52.7 46 46 46 41.1 41.1 41.1 33.7 33.7 33.7 18.2 Senior subordinated bonds n/a n/a n/a n/a 37 37 37 37 37 37 32 32 32 8 8 8 8

Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa-C

* Average issuer-weighted cumulative default rates, 1983-2004

** We use issue-weighted recovery rates based on initial issue rating, 1982-2003. Since speculative subordinated bonds are rated two notched down from company ratings and investment subordinated bond are rated one notch down, we make appropriate adjustments to arrive to the company rating.

Panel B. Expected loss rates for various company ratings and seniorities
1 year Senior Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa-C n/a 0.00 0.00 0.00 0.00 0.01 0.01 0.09 0.06 0.22 0.39 0.37 1.31 2.01 3.93 7.14 18.19 Subord. n/a n/a n/a n/a 0.00 0.02 0.02 0.11 0.08 0.26 0.45 0.42 1.52 2.79 5.46 9.91 20.46 5 years Senior n/a 0.09 0.17 0.11 0.18 0.32 0.31 0.79 1.14 1.94 3.98 5.19 11.27 16.75 20.71 28.87 49.41 Subord. n/a n/a n/a n/a 0.24 0.43 0.41 0.92 1.33 2.27 4.60 6.00 13.02 23.25 28.74 40.07 55.57 10 years Senior n/a 0.15 0.40 0.20 0.40 0.80 0.80 1.25 2.96 3.89 7.29 8.63 21.35 31.45 29.49 41.32 64.47 Subord. n/a n/a n/a n/a 0.53 1.06 1.06 1.46 3.46 4.54 8.42 9.97 24.64 43.64 40.92 57.33 72.51 20 years Senior n/a 0.89 1.70 1.55 1.32 2.26 3.18 3.34 9.69 8.48 15.90 22.05 31.22 40.24 37.34 46.42 66.63 Subord. n/a n/a n/a n/a 1.76 3.01 4.24 3.90 11.30 9.89 18.36 25.46 36.05 55.84 51.81 64.42 74.94

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Table 8. Effect on yield of bond seniority level after controlling for Moodys bond ratings
The sample consists of bond issued between 1982 and 2001. The dependent variable is corporate bond offering yield spread. The regression also includes a set of dummy variables for each

Moodys bond rating category that are not reported. Results are corrected for heteroskedasticity and clustering. Robust p-value <.0001 0.1465 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.3310 <.0001 <.0001 <.0001 <.0001

Parameter estimate Intercept 0.50971 Senior 0.01724 Callable 0.14241 Maturity <5 years -0.23702 Maturity >15 years 0.13448 Coupon 0.46524 Ln (offering amount) 0.04004 Closest benchmark treasury rate -0.59036 10 year 2 year treasury -0.00283 Financial (relative to industrial) 0.08966 Utilities (relative to industrial -0.20248 1980years<1990 0.4443 Yeara2000 0.3811 Number of observations=10,343 Adjusted R=0.8862

Variable

p-value <.0001 0.2980 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 0.7881 <.0001 <.0001 <.0001 <.0001

37

Table 9. Effect on bond yield of seniority level for each Moodys bond rating category The table below gives parameter estimates of the seniority level dummy variable for each Moodys bond-rating category. The sample consists of bond issued between 1982 and 2001.Dependent variable is corporate bond offering yield spread. Each regression includes a set of control variables defined in the text. Results are corrected for heteroskedasticity and clustering.

Rating* Aa2(AA) Aa3(AA-) A1(A+) A2(A) A3(A-) Baa1(BBB+) Baa2(BBB) Baa3(BBB-) Ba1(BB+) Ba2(BB) Ba3(BB-) B1(B+) B2(B) B3(B-) Caa1(CCC+)

Parameter estimate of seniority level -0.45219 -0.07826 -0.10463 0.09265 -0.00979 -0.00056864 0.00962 -0.01111 -0.05948 0.00107 0.00785 0.31697 0.21913 0.27039 0.05829

p-value 0.0006 0.0822 0.0004 0.0018 0.1538 0.9927 0.5318 0.4396 0.2181 0.9384 0.5339 <.0001 0.0051 0.0024 0.3819

Robust p-value 0.0006 0.0913 0.0001 0.0018 0.1538 0.9734 0.5318 0.5583 0.2104 0.8416 0.5339 <.0001 0.0019 0.0012 0.1995

N 275 789 1,207 2,084 942 983 669 492 164 203 606 361 320 435 29

Adjusted R 0.4564 0.5378 0.5625 0.5739 0.9865 0.7147 0.9938 0.9962 0.9873 0.9962 0.9969 0.9196 0.6910 0.6409 0.9924

*Parallel S&P rating is in parentheses

38