"Consequently, when a firm is in poor financial condition, subordinated debt is unlikely to be paid in full and is more like an equity claim than a debt claim. In this case, an increase in firm volatility makes it more likely that subordinated debt will be paid off and increases the value of subordinated debt. Senior debt always falls in value when firm volatility increases."
@ABSMOGHEHi David,
While studying the aforesaid chapter on Credit Risk and Derivatives, I am struggling to understand the following line with regards to valuing a senior debt.
For some reason I find this statement a bit counter-intuitive. If the firm's volatility increases, then wouldn't the firm's ability to pay off the subordinated debt weaken ? Since in times of high volatility for a distressed firm I understand that it would be difficult for the firm to pay off the obligations towards the Senior Debt leave alone Subordinated Debt. In such a case shouldn't the value decrease ? Also, if the volatility increases, the Credit Spreads would also increase thus reducing the Value of Debt (due to inverse relationship between price and yield).
I believe I might be missing something, and I apologize if it is a simplistic error.
Thanks.
Hi Nicole, I have the same question as @ABSMOGHE but in your reply, I dont see the link. Please let me know what I am missing.@ABSMOGHE
I did a search in the forum, and I believe that this thread should help to answer your question. I'm sure there are many more threads in the forum regarding senior debt (many threads came up in my search), but this one should help a bit.
Thank you,
Nicole
Hello @nansvermaHi Nicole, I have the same question as @ABSMOGHE but in your reply, I dont see the link. Please let me know what I am missing.