Junior Debt
Types of debt such as bonds that maintain a lower priority for repayment than senior debt in liquidation proceedings
What Is Junior Debt?
In the event of default, junior debt refers to bonds or other kinds of debt issued having a lower priority for repayment than other, more senior debt claims.
Junior debt is riskier for investors and has higher interest rates than more senior debt from the same issuer.
Junior debt is identical to subordinated debt and can apply to any second-tier loan that is paid immediately after senior debt is repaid. Because all higher-ranking debt will be given precedence, junior debt has a lower chance of being paid back in default.
On average, the corporate debt market is less regulated than the stock market. As a result, organizations have more options when it comes to borrowing money. For example, a company may deal with a bank to acquire a loan.
They may also collaborate with an underwriter who leads a lending syndicate composed of many investors. A company can also issue bonds with varied repayment terms.
"Junior debt" is a term that fixed-income investors should be familiar with when looking at a company's numerous bond offerings.
A company's repayment priorities are part of its capital structure, and these distinctions will have an impact if the company encounters a credit event like a default. Some factors to consider as a debt investor include:
- A company can issue a broad range of securities to generate funds from investors, and an underwriter is often responsible for arranging these products.
- Senior debt holders will prioritize repayment, followed by junior debtholders, preferred shareholders, and ultimately common stockholders.
- Institutional debt, unlike equity financing, is often provided in the main market, which involves direct interaction between firms and investors.
- Loans and bonds can be exchanged on secondary markets after being issued on the primary market, with trades facilitated by various trading organizations. Senior debt continues to bear less risk in the secondary market than subordinated debt.
Key Takeaways
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Junior Debt, also known as subordinated debt, holds a lower priority for repayment compared to senior debt in case of default. This makes it riskier for investors and leads to higher interest rates.
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Junior Debt can be used in structured products, offering investors various tranches within bond issues. Clear repayment processes for junior debt are outlined to prioritize bondholders in case of default.
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Companies' capital structures include senior and junior debt, which impact repayment priority in events like defaults. Different types of debt securities attract various investors and lenders.
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Junior Debt is riskier due to its lower repayment priority, resulting in higher interest rates compared to senior debt. It is often uncollateralized and carries more risk for investors.
Debt repayment terms
The phrase "repayment seniority" applies to all sorts of credit. For example, senior and subordinated debt are two types of loans and bonds issued. The senior loan is paid first if the borrower defaults or goes into liquidation.
It is generally a secured loan with collateral, although it can also be unsecured with certain payback seniority requirements. Senior debt is followed by subordinated debt, which has its own set of terms for repayment.
Because the senior debt has reduced risk, it often has lower interest payments and bond coupons.
Subordinated debt allows investors to accept a larger risk of lower seniority payments in the event of default in exchange for higher interest rates. Junior and subordinated debts are unsecured debts that aren't secured by anything.
Subordinated Debt in Tranches
Corporations may issue junior debt bonds in certain circumstances. Junior debt is also popular in structured products, where investors can choose from various bond tranches as part of the bond issue.
Repayment periods are sometimes a deciding factor in bond coupon rates. Therefore, the underwriter shall clearly outline the junior debt repayment processes in the event of default in the conditions revealing the investment details of a bond investment.
So, investors understand the priority accorded to the bonds in the event of failure.
For example, in many structured securities, the z-tranche is the portion of the security payable only after all previous tranches have been fully repaid.
1) The debt hierarchy
There are several types of rankings for debt groups. They are:
- First Lien Loan – Senior Secured (Sponsor equity)
- Second Lien Loan – Secured (preferred equity)
- Mezzanine Debt or Equity
- Junior Debt
2) Uses of Junior Debt
As part of debt securitization, junior debt can be utilized to issue collateralized mortgage obligations, collateralized debt obligations (CDO), or asset-backed securities. Although firms avoid this debt because of the high-interest rates, it is preferable to dilution of present ownership through the issue of new public shares.
Junior debt can also support:
- Recapitalization
- Acquisitions
- Growth capital
- Among other things
3) Recording junior debt in financial statements
Junior debt is reported and seen on a company's Statement of Financial Position, just like other obligations (Balance Sheet).
After a senior debt is classified as long-term debt in the liabilities section first (i.e., senior debt is recorded first), long-term obligations are normally reported in order of priority on the Statement of Financial Position in the event of liquidation.
4) Liquidation preference
One of the most important financial concepts in venture capital investing is liquidation preference.
The phrase expresses investors' and other stakeholders' (debt-related) preferences regarding dividend distributions and debt repayments.
Liquidation preference guarantees that particular shareholders and loan sources are paid before other stakeholders.
How junior debt works
Recently, Company A decided to issue bonds. Bondholders would be involved in the transaction. Company A owes the bondholder money. Bondholders are deemed to have seniority over shareholders.
Therefore, if Company A goes bankrupt, bondholders will receive precedence on the repayment list above shareholders.
Let's imagine Company A learns they need more money. So Bank B provides the firm with a loan. Based on the terms agreed upon by the firm and the bank, the loan with Bank B is deemed junior debt.
If company A declares bankruptcy, bondholders will be paid first, followed by bank B and the shareholders.
Because junior debt is riskier than other debt, it is usually issued with a higher interest rate. The higher interest rate compensates for the debt's inherent risk.
Subordinated debt is frequently uncollateralized, and the principal amount is typically only returned when the company sees long-term development. Mezzanine debt is another term for junior debt.
Senior Debt Vs. Junior Debt
Senior debt (subordinated debt or mezzanine debt) and junior debt (subordinated debt or mezzanine debt) are the firm's long-term or non-current obligations. Accordingly, they are a significant source of debt financing capital.
A situation arises when the cost of equity exceeds the cost of debt. While this happens, the preference swings from equity to debt. Therefore, senior debt and junior debt are essential debt financing methods.
They are beneficial to the organization in both the short and long term. Though their final goal of gathering resources is nearly the same, they have distinct traits. They both serve as a source of funding for the issuing firm. Some more information about company debt securities includes:
- Debt securities come with varying levels of risk, interest rates, repayment priorities, and the potential to attract various types of investors and lenders.
- Senior and subordinated debt are classified as non-current liabilities on the balance sheet. They are listed in order of priority of repayment at the time of bankruptcy. As a result, senior debt is recorded first, while subordinated debt is recorded second.
- Both sorts of debt generate cash, which is documented in the company's cash account. However, if this cash is used to acquire an asset, that asset is reported on the balance sheet's asset side. As a result, the cash outflow is recorded in the cash account.
A table to show all the differences between them:
| Senior Debt | Junior Debt |
|---|---|
| A sort of non-current debt that has priority for repayment in the event of liquidation or bankruptcy. | Similar to Senior Debt, but has a lower repayment priority than Senior Debt in the event of liquidation or bankruptcy. |
| Has topmost priority at the time of liquidation or bankruptcy. | Has second priority at the time of liquidation or bankruptcy. |
| A lower interest rate than junior debt to the investors. | A higher interest rate than Senior Debt to the investors. |
| Most of it is backed by collateral security. | It is rarely backed by any collateral. |
| It is a less expensive kind of debt financing for the issuing corporation. | Compared to senior debt, it is a more expensive source of debt financing for the corporation. |
| The issuing corporation above junior debt prefers senior debt. The corporation first aims to raise Senior Debt to the highest amount possible at the lowest possible interest rate. | The issuing corporation wants to issue junior debt only after exhausting all other options for Senior Debt. |
| The company's growth and profitability are unimportant to senior debt holders. They merely need timely payment of interest and the repayment of principal at maturity. | Apart from receiving returns, junior debt investors are concerned with the company's development and profitability. |
| It is not possible that the company is defaulting on Senior debt. | The company can default on this debt. |
| Due to a lack of collateral, it is difficult for small enterprises or startups to get Senior Debt. | Due to the lack of collateral, small enterprises are more likely to get junior financing than senior debt. |
| Senior debt holders are often banks or financial institutions. | Junior debt holders are typically the firm's parent company, shareholders, or the general public. |
| A senior debt covenant is an agreement between the borrower and the Senior Debt holder that ensures the borrower's reputation is maintained. | There may not be a covenant on this debt. |
| Senior unsecured debts are paid before Junior unsecured obligations. | Junior debt is only paid once the secured and unsecured senior debts have been paid. |
| Senior debtors have an extremely low risk of losing their money. |
Holders of this debt have an extremely high risk of losing money. If things go wrong, they might lose the entire principal amount. |
Researched and authored by JunFeng Zhan | LinkedIn
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