A corporation can borrow money by issuing bonds or getting a bank loan. Both are different forms of debt. “Senior” means that the debt has priority over other types of debt in bankruptcy; “unsecured” means that the debt is not secured by any specific collateral.
Senior unsecured debt refers to debt that is not backed by a specific asset and that has priority over other debts in case of bankruptcy.
Forms of Debt
A bond is a debt obligation sold to investors, usually in $1,000 denominations. A bank loan can be a term loan or a revolving line of credit. Banks either keep their loans on the books or sell them to institutional investors such as fixed-income or pension funds.
Understanding Debt Seniority
If a corporation defaults on its obligations, it can be forced into bankruptcy liquidation, in which case its assets will be sold off to repay the debts. Debts are repaid in a prescribed order of priority. Senior debt comes first; junior or subordinated debt come after it.
Think of it as a first and second mortgage. The first mortgage would be senior debt; the second mortgage would be junior, or subordinated, debt.
Exploring Asset Securitization
A mortgage can be secured by a house or other real property. A corporation may pledge specific assets such as buildings, machinery or equipment to secure a bond or a bank loan. But unsecured debt does not have any specific collateral and is backed by a corporation’s credit rating and ability to repay.
A corporation may also have several forms of unsecured debt. Some unsecured debt may have priority over other types of unsecured debt – hence “senior unsecured debt.”
Considering Debt Hierarchy
Things can get complicated – that’s why you need bankruptcy lawyers to figure out who gets paid what and when. Senior unsecured debt may have priority over subordinated debt but be subordinated to bank debt or senior secured loans.
Relation to Bond Pricing
Investors always demand returns that are commensurate with risk. All else being equal, a senior bond will pay a lower interest rate than a junior or subordinated bond because the former is safer: in bankruptcy, senior debt holders are more likely to get some or all of their money back compared to other types of debt holders. An unsecured debt has higher interest because it is not backed by any specific assets, but its holders may lose more in bankruptcy liquidation.
Advice for Selecting Bonds
You can only invest in bank debt through a fund whose holdings are professionally selected and diversified to minimize risks. That leaves you with individual bonds. Using a bond’s credit rating is the best shortcut because it takes into account all relevant aspects such as the issuer’s financial condition and the bond’s seniority and collateral.