What is Junior Debt?
Junior debt, also referred to as subordinated debt, is debt that is considered to be of a lower priority in the debt and debt repayment hierarchy. It is normally unsecured and can be provided without any collateral, making it risky. Junior debt tends to come at higher interest rates than senior debt.
If an entity goes bankrupt, subordinated debt is unlikely to be repaid, as priority will be given to senior debt obligations. The term “subordinate” is used to refer to the ranking of the debt providers’ status.
Junior debt falls below liquidators, government and tax authorities, and senior debt. In simpler terms, It is debt that is expected to be repaid after an entity’s repaid or met all other financial obligations to senior debt providers and creditors.
- Junior debt, also referred to as subordinated debt, is debt that is considered to be of a lower priority in the debt and debt repayment hierarchy.
- Junior debt is normally unsecured and can be provided without any collateral, making it risky. Also, it tends to come at higher interest rates.
- It can be secured to fund recapitalization, acquisitions, growth capital, etc.
How Junior Debt Works
To effectively illustrate how junior debt works, consider the following example:
Company ABC recently decided to issue bonds. In the transaction, there would be bondholders. The bondholder is a creditor to Company ABC, to an extent. Bondholders are considered to hold seniority over shareholders; therefore, in a case where Company ABC goes bankrupt, the bondholders will take priority over shareholders on the repayment list.
Let’s say Company ABC discovers that they require additional funding. The company secures a loan from Bank CDE. The loan with Bank CDE is considered junior debt, based on the terms and conditions agreed upon by the company and the bank. Should Company ABC file for bankruptcy, the bondholders will still take priority on the repayment list, followed by Bank CDE, and then the shareholders.
Junior debt normally comes at a higher interest rate because it is riskier than other debt. The higher interest rates compensate for the risk associated with the debt. Subordinated debt is often uncollateralized, and the principal amount of the debt is normally only repaid when the business experiences growth in the long term. Junior debt can also be referred to as mezzanine debt.
A key difference between senior debt and junior debt is that, with the latter, principal and interest payments tend to come later than they would with senior debt. Also, junior debt comes at a higher interest rate than senior debt due to the level of risk associated with a junior debt instrument.
The Debt Hierarchy
There are several types of rankings for debt groups. They are:
- First Lien Loan – Senior Secured
- Second Lien Loan – Secured
- Senior Unsecured
- Senior Subordinated
- Junior Subordinated
Uses of Junior Debt
Junior debt can be used in issuing collateralized mortgage obligations, collateralized debt obligations (CDO), or asset-backed securities as part of debt securitization. Even though companies shy away from junior debt due to the high interest rates, it is preferred over the dilution of current ownership via the issuance of new shares to the public. Also, junior debt can be secured to fund recapitalization, acquisitions, growth capital, etc.
Recording Junior Debt in Financial Statements
Junior debt, as with other liabilities, is recorded and found on a company’s Statement of Financial Position (Balance Sheet). It is recorded in the liabilities sections as a long-term debt, after senior debt (i.e., senior debt is recorded first). On the Statement of Financial Position, long-term liabilities are typically recorded in order of priority, should liquidation occur.
Liquidation preference is one of the leading financial concepts in venture capital funding. The phrase outlines the preference held by investors and/or other stakeholders (debt-related) in terms of dividend distributions and other debt repayments. Liquidation preference ensures that certain shareholders and/or debt providers receive their funds back before other related stakeholders.
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