Debt with claim priority
Debt with claim priority
Senior Debt or a Senior Note is money owed by a company that has first claims on a company’s cash flows. It is more secure than any other debt such as subordinated debt (also known as junior debt) because senior debt is usually collateralized by assets. This means the lender is granted a first lien claim on the company’s property, plant or equipment in the event that the company fails to fulfill its repayment obligations. The most common types of senior debt are Senior Term Debt and Revolving Credit Facility. These are provided by the commercial or corporate banking departments of a bank.
As shown in the diagram, financing the company through senior debt will provide the lowest risk and highest priority of repayment when compared to other securities. Debtholders, typically bondholders and banks, will be entitled to repayment before shareholders, should the company go through bankruptcy and liquidation. As it is borrowed money, each layer of debt has a corresponding interest rate payment schedule, where the company will make regular principal and interest payments. Moreover, to avoid carrying too much debt and potential insolvency, senior debtholders will prevent the company from issuing junior debts. This is stated in the senior debt covenants to protect the lender.
Debt covenants are agreements that can be rather restrictive. One of its purposes is for the company to maintain a designated credit profile. This is achieved by targeting a certain level of leverage ratios, which are debt service coverage and interest service coverage ratios. Another purpose is for the company to maintain certain business activities or refrain from one that’s outside its core operations. If a covenant is not followed, the lender has the right to either rescind it and demand immediate repayment of accrued interest and principal, or make changes to the agreement such as increasing the interest rates.
Since senior debt is considered a safe investment, lenders will receive the least amount of return for it due to fix, periodic payments. In this case, there is no benefit for a potential higher return when the company has improving financial performance. Unlike senior debt, when banks, for example, take on some junior debt of a company, they will charge higher interest rates to compensate for the risk of having a subordinate status.
Senior debt is accessible by various businesses and widely offered by major banks. These banks generally have a low cost of funding and a profitable spread between this cost and the interest rate they charge to their borrowers. Furthermore, to maintain a healthy financial system, financial regulators implement standards and requirements that encourage banks to take less risk and therefore, focus more on offering “senior” financial products.
Unsecured Senior debt is different in that it doesn’t have a pledged asset as collateral. Instead, the debtholders have a claim against the company’s general assets. If the company goes bankrupt, unsecured senior debtholders will be first in line to get paid off from the other assets of the company, excluding the pledge assets for the secured senior debtholders. Any remaining assets after this will go to the subordinated debtholders.
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