What Is Senior Debt?

Companies need liquidity/money to fund their expansion plans. Issuing debt is one such way of raising funds. This amount is used to buy additional resources and invest in labour or capital which are among the most important business expenses. In the event of insolvency, a company pays this debt first which makes this form of investing the least risky.

Senior debt is a type of low-risk debt investment as it involves some form of collateral which businesses may sell if they are unable to repay debt. However, lower risk also means lower returns. Since senior debt is a low-risk investment, it also has a lower interest rate than other debt investments like subordinate debt. Conversely, these debts are also riskier than subordinate debts.

Types of senior debt

Businesses can raise senior debt through the public bond market, bank loans and private placement sales. Broadly, there are four types of senior debt, viz. secured, unsecured, revolving and instalment.

• Secured debt

  This is one of the most common types of senior debt that involves collateral backing. This makes the debt repayment secure as the loan amount can be recovered from the selling of the collateral. Therefore, secured debt is less risky.

• Unsecured debt

  Unlike secured debt, senior unsecured debt doesn’t require collateral. The issuance of such debt depends on the credit ratings of the companies.

• Revolving debt

  This is an open-ended credit facility that can be repaid over and over as long as your business remains in good standing.

• Instalment debt

  Instalment credit is closed-ended and has to be repaid within a fixed period. In this type of debt, the interest rate decreases with every instalment paid.

Senior Debt vs Subordinated Debt

Senior debt is also known as unsubordinated debt. There are different types of unsubordinated debt or secured debt based on the level of security and repayment profile. As a result, the interest rate on this type of loan is lower.

Unlike types of unsubordinated debt, subordinated debt has a higher interest rate due to its lower priority during repayment.

Banks usually finance various types of senior debt. Banks assume lesser risk senior rank in the repayment sequence and can afford to accept a lower rate because of their low-cost sources of funding from deposit and savings accounts. Regulators also encourage banks to maintain a lower-risk lending portfolio.

Any debt that is below or behind senior debt is referred to as subordinated debt which takes precedence over preferred and common stock.

Senior Debt Covenants

Debt covenants are contractual agreements between a seller and a buyer. A credit profile may be necessary for the borrowing company, for example. This is accomplished by aiming for specified leverage ratios, such as debt service and interest service coverage ratios.

The corporation may also be compelled to continue specific business activities or abstain from engaging in any activities or investments that are not related to its primary business. If the borrower breaks the covenant, the lender can either rescind the loan and demand prompt repayment of accumulated interest and principal or make amendments to the loan agreement, such as raising the interest rate charged on the loan.