What is a Junior Security?
A junior security is a security that ranks lower in priority and seniority when contrasted against other securities. It typically comes with a lower claim against the assets and incomes of the issuer than other securities.
If a company files for bankruptcy and liquidates its assets, it must follow certain repayment preferences to determine which stakeholders are to be paid first. Senior securities (debentures, bank loans, bonds, preference shares, etc.) take priority over other stakeholders; however, based on a traditional capital structure, bondholders and senior debt lenders tend to be rapid first, leaving ordinary share and common stockholders last.
The need to have repayment preferences to prioritize stakeholders can be attributed to risk-reward profiles. Lower risk securities – such as corporate bonds – tend to take precedence over shareholders who can expect unlimited dividend payments. Senior security owners are repaid first before other parties in the event of bankruptcy.
- A junior security is a security that ranks lower in priority when contrasted against other securities.
- It typically comes with a lower claim against the assets and incomes of the issuer than other securities.
- Senior securities (these can be debentures, bank loans, bonds, preference shares, etc.) take priority over other stakeholders or junior securities; however, based on a traditional capital structure, bondholders and senior debt lenders tend to be repaid first, leaving ordinary share and common stockholders last.
An Overview of Securities
To fully comprehend what a junior security is, it is beneficial to understand what securities are the different types of securities there are. As defined by the Corporate Finance Institute (CFI), a security is “is a financial instrument, typically any financial asset that can be traded. The nature of what can and can’t be called a security generally depends on the jurisdiction in which the assets are being traded.”
The three primary categories of securities are:
1. Equity securities
Equity securities are normally stocks or shares in a company, and they generate regular earnings (dividends) for the shareholders.
2. Debt securities
Debt securities involve the selling of a security and borrowed funds. A debt security can be issued by a company, the government, or an individual and is sold to another party for a specified amount with the promise of repayment at a predetermined and agreed-upon interest rate.
Derivatives are a distinct type of security because they derive their value from an underlying asset. The underlying asset is purchased and repaid, and the price, interest rate, and maturity date are predetermined and agreed upon by the respective parties at the time of the agreement initiation.
How Junior Securities Work
To better understand the concept of junior securities, consider the following example:
Company ABC has recently issued preference shares. The company already has ordinary (or common stock) shareholders; thus, the preferred stock shareholders take seniority over the ordinary (or common stock) shareholders. If Company ABC is to file for bankruptcy today, the preference shareholders will take precedence over the common stock shareholders in terms of repayment prioritization. In such a scenario, the ordinary or common stock is referred to as the junior security.
Assume that Company ABC realizes that they require additional capital or funding. They approach Bank CDE and borrow funds. Depending on terms and conditions agreed upon by Company ABC and Bank CDE, Bank CDE is likely to be holding “junior,” and if Company ABC is to go bankrupt, then the bondholders would be paid first, followed by Bank CDE and then the shareholders.
Seniority in finance is defined as “the order of repayment in the event of a sale or bankruptcy of the issuer. Seniority can refer to either debt or preferred stock.”
Securities issued by corporations tend to come with a particular seniority attached. It is a general rule-of-thumb that senior securities are repaid or paid before junior securities. Usually, in the event of a company ending up bankrupt, debts and bonds are repaid first and then followed by junior debts.
After junior debts, preference shares follow, and ordinary shares are last. Hence, senior security holders take priority over other security holders.
CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: