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Seniority Rankings of Corporate Debt

Seniority Rankings of Corporate Debt

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. This, obviously, implies different priority of payment. The 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. As a result, 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 receive any payment.

Seniority Ranking

Within each category of debts, there are finer grades (or types) of rankings:

  1. First-Lien Loan – Senior Secured
  2. Second-Lien Loan – Secured
  3. Senior Unsecured
  4. Senior Subordinated
  5. Subordinated
  6. Junior Subordinated

Secured Debt

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 assets if the borrower defaults on the loan.

Unsecured Debt

Among unsecured debts, there are: 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 Debts?

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 considered as members of the same class. This is referred to as bonds ranking pari passu (“on an equal footing”).

Question

A UK-based group has senior unsecured bonds as well as both first and second-lien debts. Which of the following ranks higher with respect to priority of claim?

  1. Second-lien debt.
  2. Senior unsecured bonds.
  3. Senior subordinated debt.

Solution

The correct answer is A.

Second-lien debt ranks higher than either senior unsecured debt or senior subordinated debt because of its secured position.

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