A senior note is a type of bond that gives an investor a higher-priority claim compared to junior notes when a company files bankruptcy. Senior notes pay lower interest rates than junior notes but are repaid before other debts when a company defaults.
One of the biggest risks of investing in corporate bonds is default risk, which is the possibility that the company won’t be able to repay its debt. If the company goes bankrupt, bondholders have a claim on the company’s assets along with other creditors. Learn how senior notes work and what they mean for you as an investor if you own senior notes for a company that defaults.
Definition and Examples of a Senior Note
A senior note is a type of corporate bond that gives the bondholder a higher priority claim on a company’s assets and cash flows in bankruptcy than a bondholder who owns a junior note.
To understand senior notes, you need to understand the basics of corporate bonds. When a company needs to raise cash, it often does so by issuing corporate bonds. Investors receive regular interest payments, plus the return of their principal when the bond reaches maturity. But in a corporate default, bondholders will take their place in line with the company’s other creditors seeking to get paid in bankruptcy.
Some senior notes may be convertible. This means the senior note could be converted into shares of company stock, giving you the chance to own equity in the company.
During bankruptcy proceedings, bondholders stop receiving interest payments and shareholders don’t receive dividend payments.
Senior Notes vs. Senior Debt
Though the terms “senior debt” and “senior notes” are often used interchangeably, the terms have different meanings. Senior debt typically refers to secured debt, which is backed by collateral, such as a building or equipment.
Both senior notes and junior notes typically aren’t backed by collateral, meaning they’re considered unsecured debt. Sometimes, they’re referred to as senior or junior debentures.
How a Senior Note Works
Different types of senior notes reach maturity at different times. It may take up to 10 years for a note to reach maturity.
Sorting out the order in which creditors get paid during bankruptcy proceedings is extremely complex. However, creditor claims are typically paid in the following order:
- Secured creditors: Secured creditors, typically banks, are paid first during corporate bankruptcy.
- Unsecured creditors: This category includes banks holding debt that’s not backed by collateral, suppliers, and bonds.
- Stockholders: Investors who own stock in a bankrupt company get paid last during bankruptcy liquidation. Shareholders may be left with nothing if secured and unsecured creditors aren’t paid in full.
Within each category, there are complicated hierarchies. For example, suppliers, customers, and pensioners are all considered unsecured creditors. Banks can also hold debt that’s not backed by collateral. These debts may take equal or higher priority over the claims of bond investors who hold senior notes.
Senior notes are more likely to be repaid than junior notes, so they’re considered lower risk. Because there’s less risk involved, senior notes pay lower interest than junior notes. However, there’s no guarantee that you’ll be paid cash. Companies may choose to repay bondholders in stock instead. It depends on the bankruptcy and situation.
High-yield bonds, also known as junk bonds, offer higher interest payments because their risk of default is higher. Ratings agencies Moody’s, Standard & Poor’s, and Fitch grade bonds according to their creditworthiness. A bond is considered a junk bond if it has less than a Ba1 rating (non-investment grade) from Moody’s or lower than a BB+ rating from Standard & Poor’s or Fitch.
What It Means for Individual Investors
Investing in senior notes poses less risk compared to junior notes or stocks, but it isn’t risk-free. During bankruptcy, investors in senior notes get paid only after secured creditors’ claims have been paid, and other creditors may have higher-priority claims.
If you’re concerned about default, investing in senior notes of just one or two companies may not be enough to mitigate the risks. By investing in a bond fund, you could invest in hundreds or even thousands of bonds. In doing so, you may reduce your risk because you’re spreading it out.
Also, default risk isn’t the only type of risk to consider when you invest in any type of bond. Other risks to consider, whether you’re investing in senior notes or junior notes, include:
- Interest rate risk: Because bond prices typically have an inverse relationship with interest rates, there’s the risk that the bond’s market value will drop as interest rates rise.
- Inflation risk: A bond’s total return may not keep up with inflation.
- Market risk: A bond’s price could be volatile due to market conditions.
- A senior note is a type of corporate bond that carries a higher-priority claim in bankruptcy than a junior note, which means those who own senior notes get repaid first.
- Senior notes are typically unsecured debt; they aren’t secured by collateral.
- Because senior notes have less risk than junior bonds, they typically pay lower interest rates, but that doesn’t mean they’re risk-free.