How does the priority of different security holders in bankruptcy liquidation affect the required rate of return on different securities. In other words, why do bond investors have lower required rates of return than do stock investors?
When a company files for bankruptcy, a trustee is given the task of selling the assets of the company to reimburse those that have a stake in the company. A priority list is created in which the stakeholders of the company are given a position based on which they are reimbursed. The first priority is given to secured creditors, next come unsecured creditors that includes banks, suppliers and bondholders and finally come the shareholders of the company.
If the amount received from the sale of assets is more than what has to be paid to the secured creditors, the bond holders are paid. If anything remains unclaimed after the unsecured creditors are taken care of, it is distributed among shareholders of the company.
Investors look at the risk profile of the company and the chances of its going bankrupt before buying either bonds or shares. As the shareholders have the least chance of receiving anything in case the company shuts down, the required rate of return is higher than that of bondholders that are more likely to receive something if the company shuts down.
The required rate of return associated with purchase of any asset is directly proportional to the risk being taken on by the investor. As shareholders are taking on a higher risk that bondholders, their required rate of return is also higher.