Junior Debt

An unsecured debt that ranks lower in repayment priority or with a lower liquidation preference than other debts in the event of default

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

 

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.

 

Summary

  • 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. 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 is issued at an interest rate premium because it is riskier than other debt. The higher interest rate compensates 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.

 

The Debt Hierarchy

 

Junior Debt - Debt Hierarchy

 

There are several types of rankings for debt groups. They are:

  1. First Lien Loan – Senior Secured
  2. Second Lien Loan – Secured
  3. Senior Unsecured
  4. Senior Subordinated
  5. Subordinated
  6. 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

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.

 

More Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • Mezzanine Financing
  • Secured vs Unsecured Loans
  • Quality of Collateral
  • Senior Bank Loan