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What is Senior Debt?
If a company goes out of business, then the first repayment of the borrowed money that needs to be done is called Senior Debt.
Each type of financing has a different level of priority in repayment when a company goes out of business.
At the time of bankrupt of a company, the issuers of senior debt, which usually are bondholders or banks that have issued revolving credit lines, are most likely to be repaid first, followed by junior or subordinated debt holders and hybrid debt instruments such as convertible notes, the preferred stockholders get paid next and finally common stockholders who come last on the list.
The Working of Senior Debts
Senior debt is termed as an organization’s first tier of liabilities, that gets secured by a lien against some type of collateral.
Senior debt is secured by the company for a set interest rate and time period.
Depending on a preset schedule the company makes regular principal and interest payments to lenders.
Senior debts are less risky, and also lenders get a lower return for these debts. These debts generally are funded by banks.
The lower risk senior status is taken by the banks in the repayment order because they can afford to accept a lower rate because their source of funding from deposit and savings accounts are also low-cost.
Regulators additionally advocate for banks to maintain a lower-risk loan portfolio.
Senior debt holders are allowed to decide and give their opinions on how much subordinated debt a company can assume.
In case the company becomes insolvent, having too much debt could mean the business cannot pay all of its creditors.
This is the reason why senior debt holders typically want to keep other debts at a minimum.
Secured senior debt is backed by an asset that was pledged as collateral. For instance, when issuing loans lenders may place liens against vehicles, equipment, or homes.
In the event of loan default, the asset may be sold and the debt can be covered. That is not the situation with unsecured debt which is not backed by an asset pledged as collateral.
So if a business becomes insolvent, unsecured debt holders file claims against the company’s general assets.
The Difference Between a Senior Debt vs Subordinated Debt
The priority in which the debt claims are paid by a firm in the event of bankruptcy or liquidation is the main difference between subordinated debt and senior debt.
If a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation, the senior debt gets paid first before the subordinated debt.
Once the senior debt is completely paid off, the company then goes to repay the subordinated debt.
So if a company files for bankruptcy, the payment of senior debt claims is made first.
All other debt is subordinated or junior to the main debt. To pay off senior secured debt, collateral from asset-backed debts may be sold.
Then senior unsecured debt is paid using the company’s other assets. If any assets remain, then subordinated debt gets paid.
This is the reason why subordinated creditors may lose some or all of the principal and interest payments that they are owed and why their interest rates are high.
Pros and Cons of Senior Debt
Senior debt has a lot of advantages. Even so, here are some pluses and minuses if you choose a senior debt.
Pros:
- Senior debts come with great interest rates. The more a borrower shows that it’s a low-risk investment, the lower interest rate they can qualify for.
- Anyone can apply for senior debt though they will need to meet strict guidelines to qualify for these debts.
- Because the interest rates are lower the borrower will save money over other loans, whether they decide to sell their company or not.
Cons:
- Senior debt is a low-risk kind of loan. A borrower cannot qualify and get money without having collateral to back up these loans, which typically involves assets of the business itself. With that in mind, a borrower is taking a risk to borrow that money, and one should only do it if they are reasonably sure that they will be able to pay it back or they might lose everything.
- Depending on the amount that is needed, the borrower may not be able to get a big enough loan through a bank. Compared to junior debt lenders the banks generally have less money to give out.
- If a borrower has a secured senior debt loan and if they default on their payments, the lender can come after the assets that were used to secure the loan.
Conclusion
A debt and obligation which are prioritized for repayment in the case of bankruptcy is senior debt.
They have the highest priority and hence the least risky debt. So a senior debt carries or offers lower interest rates.
Senior debt is often secured by collateral, making it comparatively less risky.
