Senior debt is money borrowed by a company that must be repaid first during bankruptcy. Junior debtholders and shareholders also have a claim on the company’s assets and cash flow, but these claims are lower priority if the company defaults on its debt. Senior debt is often held by banks and secured by collateral.
Understanding senior debt is important because if you invest in a company that defaults on its debt, bondholders’ and shareholders’ claims are paid only after senior debt has been paid back. Learn how senior debt works and what it means for you as an individual if a company you invest in files for bankruptcy.
Definition and Examples of Senior Debt
A company issues debt when it needs to raise capital. Senior debt is money the company borrows that will take the highest priority during bankruptcy proceedings if a company goes out of business. Senior debt can be secured debt or unsecured debt.
Secured senior debt is backed by collateral. An example of secured debt is a building that’s financed by a mortgage. Such a claim would take the highest priority in bankruptcy because the creditor can foreclose on the building to satisfy its claim.
Unsecured senior debt is not backed by collateral. Bonds are a common type of unsecured senior debt, although some bonds are secured by collateral. A debenture is a type of corporate bond that isn’t secured by property. If a company defaults on its debt, an investor holding senior debentures, also known as senior notes, would get paid before an investor who holds junior debentures.
However, senior debentures are lower priority than secured senior debt. While creditors who hold secured senior debt have a claim on specific company assets, an unsecured senior debtholder only has a claim against general company assets.
How Senior Debt Works
There are three main sources a company can turn to for senior debt capital:
- Banks: Companies can receive both secured and unsecured loans from banks. Smaller, younger companies often need to offer collateral to raise senior debt capital. Banks are more likely to allow a larger, investment-grade company to obtain unsecured funding. Banks are a frequent source of short-term funding, with repayment periods often ranging from three to five years.
- Private placement: A private placement allows companies to offer its securities to select investors through a type of private sale. Companies often use private placements to borrow money from large institutional investors, such as insurance companies. Debt issued through private placement can vary in terms of repayment period, often ranging anywhere from five to 30 years.
- Bond market: A company can issue senior debt through the public bond market. Typically, this occurs when a company has publicly traded stock. Corporate bonds can range from short term (three years or fewer until maturity) to long term (10 or more years until maturity).
Companies are exempt from registering with the U.S. Securities and Exchange Commission when they raise capital from banks or a private sale; however, they must register with the SEC when they raise capital from the public bond market.
Senior debt is considered a relatively safe investment because senior debtholders go to the front of the line of creditors during bankruptcy. Lenders charge lower interest rates for senior debt because it’s low risk. Sometimes banks also lend a company’s junior debt, but when they do so, they charge higher interest rates because of the greater risk involved.
Likewise, senior notes typically earn less interest than a junior note issued for the same company. Because the risk is greater with junior debt, investors must be compensated for the additional risk.
What It Means for Individual Investors
Investing in senior debt, such as senior notes, offers some protection for individual investors against default risk.
It’s important to understand where you stand as an investor in terms of the creditor hierarchy if bankruptcy should occur.
Typically, banks get paid first if default occurs because they hold secured claims. Individual investors who hold senior debt are more likely to own bonds. Bondholder claims are usually part of the second tier of creditors. Senior bondholders will take higher priority over junior bondholders.
However, the type of payment bondholders receive will vary based on the company’s business, its assets, and the bankruptcy agreement. Bondholders may be paid in newly issued bonds, cash, or stock that could be worth less than what the original bonds were worth.
Investors who hold preferred and common stock account for the third and fourth tiers of creditors, respectively.
While senior debt tends to be a safe investment, it also comes with lower returns. Individual investors should weigh whether they’re willing to sacrifice higher returns in exchange for lower risk.
- Senior debt is borrowed money that a company must repay first during bankruptcy proceedings.
- Secured senior debt is backed by collateral and is considered the top tier of creditor claims. Unsecured senior debt isn’t backed by collateral and is a lower priority during liquidation.
- Companies can raise senior debt through bank loans, private placement sales, or the public bond market.