What is senior debt? Definition and example
Senior debt is debt with the highest priority of repayment. Businesses secure senior debt from large financial institutions for a set interest rate and period – payments are made on a pre-determined schedule.
When a company files for bankruptcy or liquidation its senior debt is fully paid off before subordinated debt (debt which ranks after other debts). This is because senior debt is the first level of a corporation’s liabilities.
Cambridge Dictionary defines senior debt as, “Debt that will be paid back by a company that goes bankrupt before other debt is paid back”.
Senior debt is typically secured by collateral in the form of a lien. A lien gives the lender the right to take possession of a specific asset of the borrower in the event the contract is not performed according to its terms.
For example, lenders may place liens against vehicles, equipment, or properties when issuing a loan. If the business defaults on the loan then the debt is covered by selling the assets.
Example
The CEO of a fictitious company called XYZ announces that the company is filing for bankruptcy. The company stops all operations and goes completely out of business. Secured creditors take less risk because the credit that they extended to XYZ is backed by collateral (the assets of the company). These creditors know they will get paid first because the loans they issued are considered to be XYZ’s senior debt.
Senior debt is often issued by large financial institutions with pooled capital. It carries less relative risk to junior debt or mezzanine debt because of its priority position. Junior debts, which carry a higher risk, generally pay greater yields than senior debts.
It’s common for senior debtors to prevent a business from taking out too much junior debt through what’s known as a debt covenant, which can include a maximum allowable debt/cash flow ratio. A debtor is a person who owes money.
Lines of credit and bond offerings are two examples of senior debt.