Senior debt is the debt that is first in line to be paid in the case of bankruptcy or liquidation by the debtor. In theory, this debt is paid in full before any other junior debtholders see any payment.
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A company who needs financing has many possibilities of where to borrow money. For example, they might decide to get a bank loan, issue bonds or stock. Usually, bank loans become senior debts, which means that the bank has the highest level of right to be paid first or to take benefit from the remaining assets of the company if they go out of business.
Any debt in line to be paid behind the senior debt is called subordinated debt. These are usually bondholders that will receive payment only after the claims of the senior debtholders are met. A third group that has to wait until senior and subordinated debtholders are paid is stockholders.
Senior debts are commonly considered lower risk than other forms of debt. The reason for this is that their payment is usually guaranteed by collateral. This is called senior secured debt. This means that a company will sell the necessary assets to pay this debt first. Once the senior debt is covered, the same method will be used to pay lower-priority debtholders. Under specific circumstances, unsecure senior debtholders might be subordinated by other senior debtholders.
On account that the risk of senior debt is low, their relative yield is also low. Their main benefit is that, in the case of liquidation by the debtor, they have the highest chance to receive the loan back, even when the company’s assets might not be enough to pay other junior debtholders.
This does not mean, however, that senior debts are 100% risk free. In a worst-case scenario, a company could not have the necessary assets or resources to pay in full even a secured senior debt. In these cases the lender will receive—if any—only a part of his loan, perceiving the investment as a loss.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.