Senior Debt: Definition & How Does It Work?

KEY TAKEAWAYS

• Senior debt is a type of debt that needs to get repaid if a company goes out of business.
• The debt and obligations that need to get repaid are usually prioritized. 
• Senior debt usually carries the lowest interest rate levels. This is because it often has the highest priority, but also comes with the lowest risk. 
• Collateral is often used to help repay the senior debt which makes it low risk for issuers. 
• Since subordinated debt has a lower priority when it comes to repayment, it usually has a higher interest rate.

What Is Senior Debt?

If a company, unfortunately, goes out of business, senior debt is the amount of borrowed money they need to repay first. So, if a company goes bankrupt and has a traditional bank debt, for example, they’re going to have to pay off all of the money they have borrowed. However, there are typically certain issuers that need to get paid first. 

The likes of banks or bondholders that have issued any revolving credit lines are likely to get paid first for various amounts of debt. From here, it would most likely move to junior or subordinated debt holders, which include certain hybrid debt instruments like convertible notes. 

The last issuers of senior debt to usually get paid are preferred stockholders and common stockholders.

How Does Senior Debt Work?

Senior debt is a form of debt that often requires the use of collateral that then gets secured by a lien against it. When a business secures senior debt, there becomes a specific period for repayment as well as a set interest rate for the current debt. 

Principal and interest payments are paid regularly and they’re based on the preset schedule from the lender. Ultimately, this means that senior debt is a less risky option compared to others, yet it’s not always going to provide a high return for lenders. 

Banks are some of the most common to fund and issue senior debt. And since they are more likely to be able to afford and accept a lower rate, they will usually take the lower risk senior status. This is because the funding they source is low-cost from various savings and deposit accounts. 

With secured senior debt levels, it’s protected by certain assets that are used as collateral. For example, there might be a lien placed against a company’s vehicles or equipment when issuing loans. 

In the circumstance of a loan default, the lender can sell the asset to help cover the debt. On the flip side, unsecured debt doesn’t get protected by any collateral assets. So in this case, if a company goes out of business, any unsecured debt holders would then file claims for the loan balance against their general assets for debt forgiveness. 

Features of Senior Debt

Compared to other types of debt, senior term loans come with the highest priority of repayment but also the lowest risk. Typical debt holders, like banks and bondholders, receive their repayment before any shareholders if a company goes through bankruptcy and litigation. 

Plus, since senior debt is borrowed money, debt layers are going to have specific interest rate payment schedules. And to help avoid the possibility of insolvency, senior debt holders might not allow the company to issue junior debts. This helps add an extra layer of protection for the lender against any losses. 

Example of Senior Debt

Let’s say that a company has more than one category of debt: senior debt and subordinated debt. It’s going to have certain debt obligations to both, but they’ll work in different ways. 

In this case, the company has $1 million in senior debt and $750,000 in subordinated debt. If the company happens to file for bankruptcy, they’re going to need to liquidate all assets to be able to repay the debt amounts. 

After liquidating the assets, the company has $1.5 million. It’s going to have to repay the $1 million senior debt first, leaving $250,000 of subordinated debt outstanding. This is because senior debt has the highest priority.

Summary

Senior debt can also get referred to as a senior note, and it’s any money that a company has first claims on when it comes to cash flows. It’s usually secured by collateral which makes it less risky for banks and bondholders. 

If a company goes bankrupt, they are going to have to repay its senior debt on a prioritized basis. And since it’s a lower-risk type of debt, it’s also going to come with lower interest rates.