What it means
When a company cannot pay everything it owes, the money available has to be shared out in an order set by contract and law. Preferred debt sits at the front of that queue.
Lenders in this position are repaid in full before holders of lower-ranking debt see a cent. This priority is often backed by security, meaning the lender has a legal claim over specific assets such as property or equipment.
If the borrower defaults, the lender can sell those assets to recover its money. Because the chance of loss is lower, preferred lenders accept a smaller interest rate than lenders further down the queue.
For the borrower, preferred debt is usually the cheapest source of external funding. The cost is that lenders often add covenants, which are conditions such as keeping debt below a set multiple of earnings.
A company that breaks a covenant can face higher charges or a demand for early repayment. Businesses often combine layers of funding: preferred (senior) debt, then subordinated or junior debt, then equity.
Each layer takes more risk and expects a higher return than the one above. Understanding where a lender sits in the ranking tells you a lot about both its risk and its price.
A word of caution on terminology. The phrase is used loosely, and some writers mean senior secured debt while others simply mean any debt with priority.
Check the loan agreement for the actual ranking rather than relying on the label. Lenders also look at the borrower's overall debt load, not only the ranking.
A company that already has large senior borrowings may find it hard to raise more, since a new lender would have to rank behind existing creditors. The sequence in which debts are taken on is therefore a strategic choice.
In practice
Real-world examples.
Example
A property developer borrows $5,000,000 from a bank secured on its building, ranking as preferred debt. It also raises $2,000,000 from private investors in junior notes. The bank charges a lower rate because it is repaid first if the project fails.
Example
A manufacturer is restructuring after a poor year. The board knows its senior lenders must be repaid before any other creditor, so it negotiates with them first. Gaining their agreement is the key to the rescue plan.
Example
A buyout fund finances a purchase with 60% senior debt, 20% junior debt and 20% equity. The senior portion is cheapest and most protected. Each lower layer asks for a higher return in exchange for a higher chance of loss.
Formula
Calculation
Recovery % = amount received / amount owed, paid in order of ranking.
A company is wound up with $1,000,000 available to pay creditors. It owes $600,000 to preferred (senior) lenders and $800,000 to unsecured junior creditors. The preferred lenders are repaid first, receiving $600,000 in full, a 100% recovery. The remaining $1,000,000 - $600,000 = $400,000 goes to the junior creditors, who recover $400,000 / $800,000 = 50%. The same company can be tested in a worse case. If only $500,000 were available, the preferred lenders would recover $500,000 / $600,000 = 83.3%, and the junior creditors would receive nothing, which shows how valuable priority is when assets fall short.Case study
Seen in the real world.
Quarry Hill Holdings is a fictional company created for this illustration. It borrowed $3,000,000 from a bank as preferred debt, secured on its machinery, and $1,500,000 from a lender who accepted a lower ranking at a higher interest rate.
When a major customer went bankrupt, Quarry Hill could no longer keep up with payments and its assets were sold for $3,300,000. The bank received its full $3,000,000 first, leaving only $300,000 for the junior lender.
The junior lender recovered 20% of its loan, and the illustrative case shows why it had demanded a higher rate. The bank's lower rate was the price of security and priority. The junior lender, by contrast, had the loudest voice when terms were later renegotiated.
Watch out
Common mistakes.
- Confusing preferred debt with preferred shares. Preferred debt is a loan with repayment priority, while preferred shares are a form of equity.
- Assuming priority guarantees full repayment. If the assets are worth less than the senior debt, even senior lenders can lose money.
- Ignoring covenants. Cheap senior debt often comes with strict conditions that can limit what the company is allowed to do.
Questions
People also ask.
Is preferred debt the same as senior debt?
In most usage yes, though the exact meaning depends on the loan agreement, so check the ranking clause. Intercreditor agreements, which set out how lenders share security, are a good place to look.
Why is its interest rate lower?
Lenders with first claim on assets face less risk of loss, so they accept a lower return. The difference between senior and junior rates can be several percentage points.
Who is repaid after preferred debt?
Subordinated or junior creditors come next, followed by preferred shareholders and finally ordinary shareholders.
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