What Is a Senior Debt & How Does It Work [The Guide for 2021]

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In the financial world, there has to be some kind of security for bank debt financing. The larger the sum of the debt is, the more security it will require. But is that always the case? What does this have to do with senior debt

Read on to find out! 

What Is Senior Debt?

Senior debt is debt that must be repaid first, before any other credit when a company is facing liquidation, i.e. it is the loan with the highest priority of repayment. Providers of this kind of loans are usually commercial banks, credit, and insurance companies.

If a company is facing financial collapse, the providers of this loan are most likely to be compensated before all other lenders.

Did you know: If a company files for Chapter 11 bankruptcy, new lenders can come in to fund the company’s debt and provide senior debt relief saving the company from financial collapse. Debt relief companies are another viable option when a company needs help repaying its debt. 

How Does It Work?

In order to define how senior debt works, let’s first see what it consists of.

Capital Structure 

Capital structure is the way a company is financed including its equity as well as debt, such as bank credit debt, senior debt instruments, and other bonds including common equity or preferred stock. Various liabilities can have different seniority levels (priorities of payment). Most senior or highest-ranking debts have the first claim on the assets in the event of default. They are followed by subordinated (junior) debt, preferred equity, and common equity. Junior debt, in turn, has priority over preferred and common equity. 

Payments Schedule, Interest Rates, and Lenders

The company makes interest payments to lenders on a predetermined schedule. This makes the debt less risky but also yields less return for lenders. Senior debt financing is mostly provided by commercial banks, credit, and insurance companies.

Senior Lender Risk and Funding

Senior lenders usually hold a low-risk position in the repayment arrangement. That’s because they can generally manage to obtain a lower grade of risk given their inexpensive source of funding from down payments and savings accounts. 

Senior Lender Rights

Lenders may be free to express their opinions on how much subordinated debt a company should accept. If the firm is liquidated, large debts may mean that the business is not in a position to repay all of its borrowers. That’s why a senior lender usually wants to restrain from taking on additional debt unless it is really necessary.

Tranches Priority

Senior funded debt loans are accepted in tranches such as A, B, C, and D portions. Letter A tranche is paid with amortization, while the rest of the tranches are paid without amortization. These portions are usually sold to commercial financial institutions, and loans in the B, C, and D tranches are generally sold to hedge funds and mutual funds.

Did you know: A tranche is another word for “portion.” It is used to explain securities that can be divided into pieces and afterward sold to investors. Tranches are usually backed by mortgages and come with different levels of risk, rewards, and maturities. 

Senior Debt vs Subordinated Debt

Subordinated or junior debt is the debt that comes after the first-priority (senior) liabilities. 

The key differences between senior and subordinated debt are given in the following table:

Feature Senior debt Subordinated debt
Risk Low  High
Interest rate Low  High
Priority of repayment Prime Secondary

Example of Senior Debt and Subordinated Debt Repayment

When a business files for bankruptcy, the court prioritizes the unpaid senior debt loans that must be paid using the organization’s liquidated assets. 

So, if a company has debt A with a total value of $2 million and debt B with a total value of $1 million, debt A is a senior liability, and debt B is subordinated debt. Then, when the company files for insolvency, it must sell all of its assets to repay its creditors. If the company’s assets are liquidated for $2.5 million, it is obliged to pay off the $2 million sum of its debt A first. Only one half of the remaining junior debt B is repaid because of the lack of funds. 

Did you know: A common example of subordinated debt is mezzanine debt. It is one of the highest-risk debts and can be structured either as debt or as preferred stock

Senior Secured vs Senior Unsecured Debt

First-priority debt can be secured and unsecured: 

  • Senior secured debt funds are backed by an asset that was pledged as a guarantee. For instance, lenders may set liens against devices, vehicles, or homes when giving loans. On the condition that the loan proceeds into default, the asset might be offered for sale to cover the money owed. 
  • Unsecured senior debt is not supported by securities for the repayment of the loan. If the entity goes bankrupt, unprotected debt holders file a case against the organization’s general resources. 

Did you know: When planning on taking on new debt, individuals can also choose between secured and unsecured credit cards

Key Takeaways

Senior debt is debt with the highest repayment priority in case of a company’s insolvency. 
It comes with the lowest risk. Likewise, this type of debt lending usually offers lower interest rates.
There is senior secured debt and unsecured senior debt. However, nearly all senior loans are entirely secured and provided by private banking institutions or unitranche funds.
Subordinated debt is repaid after senior loan providers are paid in full. Subordinated debt is riskier, which is why it comes with higher interest rates and long-term liability. 
Senior providers have the right to decide how much new debt the company can take on. 

Debt Covenants

Debt covenants are agreements between the borrowers and senior lenders, which can be quite limiting. In particular, the borrowing firm may be required to maintain a designated credit line. This can mean selecting a certain type of financial leverage ratios, such as the debt service coverage ratio. 

Debt covenants can be either affirmative or negative, and they may require the company to continue with certain business actions or withhold from taking any actions that are out of its core business functioning. 

Did you know: If the borrower of the senior funded debt does not comply with the covenant, then the lender has the right to either cancel the loan and demand an instant refund of the principal and the accumulated interest or to make changes to the loan contract. This includes increasing the rate of interest.

Is It Safe to Invest in Such Debt?

In financial circles, senior debt is by definition considered a safe investment because:

  • Senior loan providers receive a very low amount of return for it. 
  • This sort of credit is offered by numerous companies and major banks. They are generally cost-efficient when it comes to financing. 
  • Financial controllers implement quality standards and conditions that motivate banks to avoid unnecessary credit risk and concentrate on offering more “senior” financial products.

In Conclusion 

There are many types of debt. First-priority (senior) liabilities are characterized by a higher priority of repayment compared to other types of debt. They are balanced by low risk and low-interest rates. All this makes them one of the safest investments for lenders and borrowers alike. 

FAQ

What happens if you can't pay senior debt?

If a company becomes insolvent, its additional assets such as property, buildings, and equipment are sold to cover the debt. In such a case, the providers of senior secured debt funds are the first in line for repayment. Sometimes, other companies may prevent liquidation by funding the company’s debt and these become super-senior lenders.

What are current senior debt interest rates?

The interest rates on senior bank debt loans are generally floating rates that are periodically balanced. These rates provide investors with added profits in the event that the interest rates rise while the debt commitments are still in place.

What is the difference between senior and junior debt?

Senior debt has the highest priority and, therefore, the lowest risk. Whereas junior debt has higher interest rates given its low repayment priority.

Sources

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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