How Debt Seniority Affects CDS Triggers, Recovery, and Implied Default Risk

# Debt seniority and probability of default


# Debt seniority and probability of default












I would like to ask if different debt seniorities ( like senior unsecured bonds and subordinated bonds) have different probability of default?

(Before edited I used debt tiers instead of seniority but I guess that is not the correct terminology)

For example, my initial understanding was that different debt tiers have different priority in a case of a default and when the issuer defaults on a payment it is actually defaulting on all the debt that it has been issued. I was justifying that by assuming that when the company had to pay interest on a date and was unable to (for let's say subordinated bonds) it would actually be unable for all the different seniority of bonds but it would be obliged to pay the most senior ones. Hence issuer defaulting as whole and paying the most senior creditors.

But after reading an article regarding 2014 ISDA CDS definitions I saw that CDS contracts will be triggered based on the seniority of the debt that has been defaulted hence making my initial assumption incorrect and that different seniorities can default separately.

Any insight regarding this would be appreciated!!

Many thanks!!

## Answer by Dimitri Vulis (score 5, accepted)

https://quant.stackexchange.com/a/69779

A CDS contract has a "reference entity" (obligor, bond issuer) and a "reference obligation" (the specific bond that needs to default, rather than a tier). Read https://www.isda.org/a/EYEgE/Credit-Derivatives-Disclosure-Annex-July-2021.pdf for lots of very detailed discussions of how CDS works.

But if you look at the single-name consensus CDS curves published by IHS MarkIt here https://www.theice.com/cds/MarkitSingleNames.shtml you will notice they they all have tier SNRFOR (meaning senior unsecured) now. People used to trade CDS referencing subordinated debt. People also used to trade CDS on preferred equity, triggered by not paying dividend. Since 2008 they pretty much don't anymore.

If a credit event happens to the reference entity (for example https://www.cdsdeterminationscommittees.org/cds/europcar-mobility-group-s-a/ ) then if the obligations that defaulted trigger cross-default on the reference obligation, then the protection buyer collects the notional minus the value of the defaulted bond. Everyone does cash settlement these days. If the reference entity has both senior and subordinated debt, then separate auctions may be held for each tier. For example, when Dura Automotive defaulted in 2006, senior was 24, but subordinated was 3.

If someone really wanted physical settlement, the protection buyer could still deliver some bond pari passu with the reference obligation and get the full notional in cash. But if the ref ob is senior, then they can't deliver sub that it not pari passou.

So, if you were to trade a CDS choosing a subordinated bond as the reference obligation (you'd have great difficulty finding someone to trade this with!), then the physical PD is really the same, but the CDS spread would probably be more than for the senior debt of the same reference entity because the recovery would be less. Further, if you observe spreads for both senior and sub (unlikely), and make some assumptions about their recoveries, then you arrive at different risk-neutral PDs.

Edit: I wrote the above in 2022. As of 2026, it's no longer true that all quotes are SNRFOR, which denotes Senior Unsecured Debt (Corporate/Financial), (onshore/external-law) Foreign Currency Sovereign Debt (Government). S&P Global / IHR Markit now has some quotes for SNRLAC (Senior Loss Absorbing Capacity, bailed-in before SNRFOR) and SUBLT2 (Subordinated / Lower Tier 2, junior to both SNRFOR and SUBLT2).

However I still don't see any MarkIt quotes for debt tiers: JRSUBUT2 – Junior Subordinated or Upper Tier 2 Debt (Banks); PREFT1 – Preference Shares, or Tier 1 Capital (Banks); SECDOM – Secured Debt (Corporate/Financial) or Domestic Currency Sovereign Debt (Government).

And they still don't have a separate standard designation for onshore/local-law hard/external currency government debt. Historically, some governments have defaulted on these without defaulting on other tiers, and people have traded CDS or such debt.

Historically, there have been a few examples of financial institutions defaulting on additional tier 1 (SNRLAC) with 0 recovery and without defaulting on other tiers, e.g. Swiss, Yes Bank, Banco Popular. Also Allied Irish Banks (AIB) defaulted on legacy subordinated debt.