Senior Debt: What It Is, Why It's Less Risky

What Is Senior Debt?

Senior debt is borrowed money that a company must repay first if it goes out of business. Each type of financing has a different priority level in being repaid if the company goes out of business. If a company goes bankrupt, the issuers of senior debt, which are often bondholders or banks that have issued revolving credit lines, are most likely to be repaid, followed by junior or subordinated debt holders and hybrid debt instruments such as convertible notes, then preferred stock holders. Common stock holders are last on the list.

How Senior Debt Works

Senior debt is a company’s first tier of liabilities, typically secured by a lien against some type of collateral. Senior debt is secured by a business for a set interest rate and time period. The company provides regular principal and interest payments to lenders based on a preset schedule. This makes the debt less risky, but also commands a lower return for lenders. Senior debt is generally funded by banks.

The banks take the lower risk senior status in the repayment order because they can generally afford to accept a lower rate given their low-cost source of funding from deposit and savings accounts. In addition, regulators advocate for banks to maintain a lower risk loan portfolio.

Senior debt holders may be able to voice their opinions on how much subordinated debt a company assumes. If the company becomes insolvent, carrying too much debt may mean the business cannot pay all of its creditors. For this reason, senior debt holders typically want to keep other debt at a minimum.

Secured senior debt is backed by an asset that was pledged as collateral. For example, lenders may place liens against equipment, vehicles or homes when issuing loans. If the loan goes into default, the asset may be sold to cover the debt. Conversely, unsecured debt is not backed by an asset pledged as collateral. If a business becomes insolvent, unsecured debt holders file claims against the company’s general assets.

Senior vs. Subordinated Debt

The difference between subordinated debt and senior debt is the priority in which the debt claims are paid by a firm in bankruptcy or liquidation. If a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation, the senior debt is paid back before the subordinated debt. Once the senior debt is completely paid back, the company then repays the subordinated debt.

Thus, if a company files for bankruptcy, senior debt claims are paid first. All other debt is subordinated (junior). Collateral from asset-backed debts may be sold to pay off senior secured debt. Senior unsecured debt is then paid using other company assets. If any assets remain, subordinated debt is paid. For this reason, subordinated creditors may lose some or all of the principal and interest payments that they are owed.

Example of Senior Debt

In July 2016, Alejandro Garcia Padilla, governor of Puerto Rico, announced that Puerto Rico would default on $779 million in constitutionally-backed general obligation debt, its most senior debt. The Commonwealth had been focusing on covering services required for its citizens rather than paying its debt obligations. The previous month, President Barack Obama signed into law a bill providing a debt restructuring process, which stopped any litigation that would have resulted from the default.

A federal oversight board was also implemented to manage Puerto Rico's finances. The general obligation (GO) debt is a category of debt that the United States had not defaulted on in decades. Unlike municipalities, Puerto Rico is not covered by Chapter 9 bankruptcy laws.