How does seniority affect LGD assumptions in credit models?

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AcadiFi · Accepted Answer

Loss Given Default reflects recovery after default, and seniority determines the claim priority against the bankrupt estate. Moody's Ultimate Recovery Database suggests the following averages for North American nonfinancial corporates:

| Seniority | Avg Recovery | LGD |
|-----------|--------------|-----|
| Senior Secured Bonds | 62% | 38% |
| Senior Unsecured Bonds | 42% | 58% |
| Senior Subordinated | 30% | 70% |
| Subordinated | 24% | 76% |
| Junior Subordinated | 18% | 82% |

For a concrete example, Zenith Steel defaulted in 2024 with $800M senior secured first-lien, $500M senior unsecured, and $200M subordinated notes outstanding. Enterprise value recovered $900M. Senior secured received full $800M (100% recovery on secured claim), unsecured received $90M (18%), subordinated received zero.

Key adjustments for modeling: (1) Industry effects - utility recoveries average 80%, retail recoveries often below 30%. (2) Economic cycle - Altman's recovery-default correlation shows recoveries drop 20-30 percentage points in recessions because distressed assets sell for less. (3) Collateral quality - real estate lends higher than intangibles. (4) Country - US bankruptcy processes generally yield higher recoveries than emerging markets.

For Basel IRB, supervisory LGD downturn values are 45% for senior unsecured, 75% for subordinated. Advanced IRB banks estimate their own LGDs subject to regulatory floors. On the FRM exam, expect seniority tables and recovery rate adjustments by industry and cycle.

How does seniority affect LGD assumptions in credit models?

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