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. Various debt obligations can have different seniority rankings, which means different priority of payment. Most senior or highest-ranking debts have the first claim on the assets in the event of default.
Secured and Unsecured Debt
Secured bonds have a direct claim (usually a pledge) from the issuer on certain assets. On the other hand, 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. This simply means that secured bondholders will get paid in full before unsecured bondholders get paid anything.
Within each group of debt, there are finer grades (or types) of rankings:
- First Lien Loan – Senior Secured
- Second Lien Loan – Secured
- Senior Unsecured
- Senior Subordinated
- Junior Subordinated
Within secured debt, there is the first lien debt, which is the highest-ranking debt. First lien debt refers to a pledge of certain assets.
Pledged assets are usually transferred to the lender from the borrower to secure the debt. Ownership of the asset remains with the borrower during the loan period. When the debt has been repaid, the pledged asset is transferred back to the borrower. The lender assumes ownership of the loan if the borrower defaults on the loan.
Within unsecured debt, there is senior unsecured debt, senior subordinated 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%.
Why Issue Different Kinds of Debt?
The reasons for issuing different seniority rankings are that:
- The issuers are interested in optimizing the cost of capital; and
- 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?
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 debt 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