What Type of Bond Is a Senior Note and How Does It Work?

What Is a Senior Note?

A senior note is a type of bond that takes precedence over other debts in the event that the company declares bankruptcy and is forced into liquidation. Because they carry a lower degree of risk, senior notes pay lower rates of interest than junior bonds.

Key Takeaways

  • Senior notes are bonds that must be repaid before most other debts in the event that the issuer declares bankruptcy.
  • That makes senior notes more secure than other bonds.
  • That greater level of safety means investors earn slightly lower interest rates.

Understanding the Senior Note

Senior notes typically have shorter maturity times than other bonds. The time lengths vary according to the issuer:

  • Corporate senior notes mature in 10 years or less
  • Municipal bond senior notes mature in one year or less
  • U.S. Treasury senior notes mature in two to 10 years

Senior notes may or may not be backed by specific assets that are pledged as collateral. Therefore, in the event that the company is forced into liquidation, holders of unsecured senior notes may not recoup their principal and interest in full.

Convertible senior notes may be held to maturity or converted into shares of the company's common stock.

If a liquidation occurs, secured debt is repaid first by selling the collateral backing the debt, then senior note-holders are paid, then holders of other unsecured debt, if any assets remain.

How Bonds Are Rated

Standard & Poor's and Moody's Investors Service, the two largest bond rating firms, rank bonds based on their judgment of the issuer's ability to repay the principal and the interest payments on time. The rating for a senior note, like other bonds, is based on the creditworthiness of the issuer, including its ability to generate consistent earnings with which to finance debt payments.

Formula for Rating

A commonly-used formula that rating agencies employ to analyze creditworthiness is the interest coverage ratio. This formula is defined as the ratio of earnings before interest and taxes divided by interest expense.

This ratio documents how much in earnings the company generates, as a multiple of interest expense. The larger the ratio, the more revenue a firm generates that can be used to make interest payments.

Convertible Senior Notes

Some senior notes are convertible into shares of the issuer's common stock. In that case, investors may choose to hold senior notes until maturity or to convert the notes into a specified number of common stock shares.

For example, let's assume that a $1,000 senior note has a conversion option that allows an investor to convert their holding into 20 shares of common stock. If the market price of the common stock is $60 per share, the investor can convert the senior notes into shares worth $1,200. The investor then owns equity in the company instead of owning debt.

Senior Note Vs. Senior Debt

A senior note is not the same thing as senior debt, although the terms are often used interchangeably. Senior debt is a broader term that is used to describe all of a company's debts that have priority status in the event of bankruptcy. Most senior debt is collateralized.