The various debt obligations can have different seniority rankings or priority of payment.
The capital structure is the composition of a company’s debt and equity such as bank debt, bonds of all seniority rankings, preferred stock, and common equity. Most senior or highest-ranking debt has the first claim on the cash flow and assets.
There is secured debt and unsecured debt. Unsecured bonds are often referred to as debentures. Secured debt has a direct claim (usually a pledge) from the issuer on certain assets. Unsecured bondholders have only a general claim on the issuer’s assets. In the event of default, unsecured debtholders’ claims are ranked below those of secured creditors.
- First Lien Loan – Senior Secured
- Second Lien Loan – Secured
- Senior Unsecured
- Senior Subordinated
- Junior Subordinated
Within each group of debt, there are also finer grades or types of rankings. Within secured debt, there is the first mortgage and the first lien debt, which are the highest-ranking debt. First lien debt or loan refers to a pledge of certain assets.
Within unsecured debt, there is senior unsecured debt, subordinated debt, and junior subordinated debt. The lowest priority of claims frequently has little or no recovery in the event of default. In other words, loss severity could be as high as 100%.
The reasons for issuing different seniority rankings are that:
- The issuers are interested in optimizing the cost of capital
- It is less expensive to offer subordinated debt, and subordinated debt does not dilute existing shareholders.
All creditors at the same level of capital structure are accepted as one, single class, which is referred to as bonds ranking pari passu (“on an equal footing”).
A UK-based group has senior unsecured bonds as well as both first and second lien debt. Which of the following ranks higher with respect to priority of claim (or seniority)?
A. Second lien debt
B. Senior unsecured bonds
C. Senior subordinated debt
The correct answer is A.
Second lien debt ranks higher than either senior unsecured bonds or senior subordinated debt because of its secured position.
Reading 56 LOS 56c:
Describe seniority rankings of corporate debt and explain the potential violation of the priority of claims in a bankruptcy proceeding