Final answer:
The recovery rate on defaulting debt is the lowest for subordinated debt or high-yield bonds because they are lower in the repayment hierarchy and are issued by riskier borrowers, offering higher interest rates to compensate for the higher likelihood of default.
Step-by-step explanation:
The recovery rate on defaulting debt is typically the lowest for subordinated debt or high-yield bonds. When a firm defaults, there is a legally-defined order in which debts are to be repaid. Senior secured debt is usually backed by collateral, so it has a higher recovery rate, while subordinated debt, which also includes high-yield or junk bonds, stands lower in the hierarchy during the recovery process. Such high-yield bonds offer higher interest rates to compensate for their higher default risk. The chances of repayment are less when compared to more secured forms of debt.
Firms issuing high-yield bonds are often considered riskier borrowers, which necessitates the higher interest to attract investors. In the event of default, the holders of such bonds may recover very little as assets are used to first satisfy senior debt obligations. Since commercial paper is an unsecured form of a short-term debt instrument, it also carries a higher risk but usually not as high as subordinated debt because it often is not associated with firms in distress.