What it means
A company that borrows can issue debt with different ranks. Investor.gov defines a senior bond as a bond that has a higher priority than another bond's claim to the same class of assets in a default or bankruptcy.
A senior note follows the same idea, and it is often an unsecured note, which means it is not backed by specific collateral. The ranking matters most when the issuer fails.
Assets are used first to pay secured creditors from their collateral, then senior unsecured creditors come next, then subordinated creditors, and shareholders are paid last. A holder lower down gets paid only if enough is left.
The SEC's bulletin on corporate bonds explains that a bond buyer is a lender to the company and receives interest and principal, not ownership. The buyer does not share in extra profits.
This is why credit quality and ranking decide most of the return. Senior notes usually pay lower yields than subordinated debt, because investors accept a lower coupon when they expect to recover more if the issuer fails.
Credit rating agencies rate the notes on issuer strength and ranking. The term does not mean the note is safe, since a senior note of a weak company can be riskier than a subordinated note of a very strong one, and the issuer's cash flow, debt load and covenants matter as much as rank.
Some senior notes are convertible, which lets the holder exchange them for shares, while others are secured, with collateral behind them. Terms differ, so the indenture, which is the contract that sets the rank, covenants and default rules, should be read.
A note's label alone does not show how much protection it carries. The law of priority and the recovery process differ by country and by insolvency system.
In the US it follows the Bankruptcy Code and the contract terms. The legal rules and the offering document should be checked before relying on a rank.
In practice
Real-world examples.
Example
A fictional company liquidates with $10 million of assets. It owes $6 million on senior notes and $5 million on subordinated notes. The senior holders are paid $6 million, or 100%, and the subordinated holders receive the remaining $4 million, or 80% ($4 million / $5 million).
Example
An investor buys $100,000 of senior notes with a 5% coupon and $100,000 of subordinated notes from the same issuer at 7%. The yearly interest is $5,000 and $7,000. The extra $2,000 is what the investor is paid for taking the lower rank.
Example
The issuer has a 4% chance of default. Senior notes would recover 90%, a loss of $10 in $100, and subordinated notes would recover 40%, a loss of $60. The expected loss is 0.4% for the senior (4% x 10%) and 2.4% for the subordinated (4% x 60%).
Formula
Calculation
Recovery rate = Amount received / Amount owed. With $4 million / $5 million = 80%.
Expected loss = Probability of default x (1 - Recovery rate). With 4% x (1 - 0.90) = 0.4%.
Coupon income = Face value x Coupon rate. With $100,000 x 5% = $5,000.
Worked comparison. Take a senior note that would recover 90% and a subordinated note from the same issuer that would recover 40%, with a 4% chance of default. The senior expected loss is 4% x (1 - 0.90) = 0.4%, and the subordinated expected loss is 4% x (1 - 0.40) = 2.4%, a difference of 2.4% - 0.4% = 2.0%. If the subordinated note pays a 7% coupon against 5% on the senior note, the extra 2.0% of coupon roughly offsets the extra 2.0% of expected loss, which is why higher yield on junior debt is a payment for risk, not a free gain.Case study
Seen in the real world.
This case study is fictional and illustrative. Noor, 51, in Kuala Lumpur, wants steady income and compares two bonds from the same fictional manufacturer. One is a senior unsecured note at 5%, and the other is a subordinated note at 7%. She reads the offering documents and sees that the senior note ranks ahead in default.
She also sees that the company has a large amount of secured bank debt that ranks ahead of both. She checks the rating and the company's interest cover. She splits her investment, putting most in the senior note and a small amount in the subordinated one. A year later the company's profit falls.
The price of the subordinated note drops more than the senior note, and she is glad she kept most in the higher rank. Noor's last step is to write down what she would do if the issuer's rating were cut again. In this illustrative story she sets a limit of 10% of her bond holdings in subordinated paper and decides in advance to sell if the company's interest cover drops below a level she has noted. Deciding the rule while calm is the lesson she takes from the episode.
Watch out
Common mistakes.
- Assuming a senior note is safe when the issuer itself is weak.
- Ignoring secured debt that ranks ahead of senior unsecured notes.
- Skipping the indenture, which sets the rank, covenants and default terms.
Questions
People also ask.
What is a senior note?
It is a debt security that ranks ahead of junior debt and shareholders if the issuer defaults or goes bankrupt.
Why do senior notes pay lower interest?
Holders expect to recover more if the issuer fails, so they accept a lower yield than on junior debt.
Are senior notes secured?
Not always. Many are unsecured, while others have collateral. The offering document states which applies.
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