Liquidation preference is used in fixed-income investments, particularly in bonds and preferred stocks. It refers to the order in which investors are paid in the event of a company's liquidation, bankruptcy, or sale. Investors with a higher liquidation preference have a higher priority in receiving their investment back before others. Understanding liquidation preference is essential for fixed-income investors as it helps them assess the risk associated with their investments.
Which type of security has the highest liquidation preference?
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A) Senior debt has the highest priority in the event of liquidation, meaning it is paid before other debts and equity securities. B) Subordinated debt has a lower priority than senior debt in the event of liquidation. C) Preferred stock has a higher priority than common stock but a lower priority than debt in the event of liquidation. D) Common stock has the lowest priority in the event of liquidation.
What is the primary risk associated with holding subordinated debt?
A) Interest rate risk is the risk that changes in interest rates will negatively affect the value of fixed-income investments. B) Reinvestment risk is the risk that an investor will not be able to reinvest cash flows from a fixed-income investment at the same rate of return. C) Credit risk is the primary risk associated with holding subordinated debt, as it has a lower priority in the event of liquidation and may not be fully repaid if the issuer defaults. D) Call risk is the risk that a bond issuer will redeem a bond before its maturity date, forcing the investor to reinvest at a lower interest rate.
In the 2008 financial crisis, many companies faced bankruptcy and liquidation. Investors holding senior debt and preferred stock were paid before those holding subordinated debt and common stock.
In the event of a company's liquidation, which type of security is paid last?
A) Senior debt has the highest priority in the event of liquidation and is paid first. B) Subordinated debt has a lower priority than senior debt and is paid after senior debt. C) Preferred stock has a higher priority than common stock but a lower priority than debt in the event of liquidation. D) Common stock has the lowest priority in the event of liquidation and is paid last.
A company has issued both senior debt and subordinated debt. If the company goes bankrupt and its assets are liquidated, investors holding the senior debt will be paid first, followed by those holding the subordinated debt. If there are insufficient funds to pay all investors, those holding subordinated debt may not receive their full investment back.
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Example Series 65 Example Practice Question
In liquidation's preference game, senior debt will stake its claim. Preferred stock is next in line, while common stock waits behind.