What are Senior Notes

Senior notes are debt securities (bonds) that take precedence over other types of debt, in that senior note-holders are the first to be paid if any assets are left over after a company's liquidation, following bankruptcy proceedings. Senior notes pay lower coupon rates of interest than junior unsecured bonds, because they boast a higher level of security and carry a reduced risk of default.

Key Takeaways

  • Senior notes are debt securities that give the note holders the first crack at recovering their funds, in the even that the company declares bankruptcy and liquidates its assets.
  • Because senior notes are more secure and less likely to default than junior unsecured bonds, they pay relatively lower coupon rates.
  • Traditionally, senior notes have shorter maturity time periods than other bonds.

BREAKING DOWN Senior Notes

Unlike senior debt, senior notes are not necessarily backed by specific assets pledged as collateral. Consequently, the bondholder may not receive his or her full principal and interest, in the event of liquidation. If a liquidation occurs, secured debt is repaid first by selling the collateral backing the debt, then senior note-holders are paid, followed by payments to other unsecured debt holders, if any assets remain.

Factoring in Maturity Dates

Senior notes typically have shorter maturity time periods than other bonds. Depending on the issuer, the senior note maturity schedules are as follows:

  • Corporate issued 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

How Bonds Are Rated

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

The interest coverage ratio, defined as the ratio of earnings before interest and taxes divided by interest expense, is a commonly-used formula that ratings agencies employ to analyze creditworthiness. This ratio documents how much in earnings the company generates, as a multiple of interest expense. The larger the ratio, the more earning revenue a firm generates, that it may use to make interest payments.

Instances Where Notes Are Convertible

Some senior notes are convertible into shares of the issuer's common stock. Investors may choose to hold senior notes until maturity, or they may elect to convert the notes into a specific 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 his holding into 20 shares of common stock. If the market price of the common stock increases to $60 per share, the investor owns shares worth $1,200 if he chooses to move forward with the conversion, which lets him own equity in the company, in lieu of owning debt.

[Important: The term "senior note" is often incorrectly interchanged with the term"senior debt".]