DEFINITION of Junior Security
A security that ranks lower than other securities in regards to the owner's claims on assets and income in the event of the issuer becoming insolvent.
BREAKING DOWN Junior Security
When bankruptcy occurs, holders of both preferred shares and debt securities have first claim on the remaining assets. Only after preferred shareholders have been paid back, remaining assets (if any) are divided among common shareholders, whose subordinate shares are aptly referred to as “junior securities”.
The term “junior securities” also relates to bankrupt companies who raised money from both debt financing and banks loan. For example, say The World’s Best Widget Company urgently needed operating capital, to open a new plant, so they consequently issue a five-year bond, while simultaneously receiving an infusion of bank capital. Should the company subsequently go belly up, the bondholders would likely be first in line to absorb any leftover cash, and then the bank would be entitled to collect assets. In this case, the bank is considered to be a junior security holder.
The Way Assets are Split
Lending banks who are junior security holders may impose higher interest rates on loans they make precisely because of their subordinated status and their high risk of never receiving any portion of a defaulting company's post-bankruptcy scraps. Incidentally, in such a scenario, the preferred shareholders of a defaulting company are third in line to collect any leftover money, after the bondholders and the lending bank. And in the highly unlikely situation where there’s still any money left after the dust settles, common shareholders are entitled to collect assets. However in most cases, there’s seldom anything else to be claimed. The payout structure of a company in bankruptcy is governed by the Absolute Priority Rule, which states that in liquidation, certain creditors must be satisfied in full before any other creditors receive any payments.
Generally speaking, investors should be cautious of taking on junior securities, because they are viewed as speculative. Interestingly, the Investment Company Act of 1940 stated in its Findings and Declaration of Policy, “The national public interest and the interest of investors are adversely affected when investment companies, by excessive borrowing and the issuance of excessive amounts of senior securities, increase unduly the speculative character of their junior securities.”
Junior security holders should consequently monitor companies they invest in, for extravagant borrowing, and react accordingly, by pairing their junior securities with senior securities, in order to diversify their portfolios and lower their risk profiles.