Senior Security: Definition, Examples, Rankings, Tradeoffs

What Is a Senior Security?

In the event of a company's bankruptcy or liquidation, a senior security is one that ranks highest in the order of repayment before other security holders receive a payout. Senior securities are typically considered the safest offering by a company because in the event of default the senior security holders will be paid any funds owed before investors in lower ranking securities.

Understanding Senior Security

With respect to a company’s capital structure, seniority refers to the order of repayment to security holders in the case of a default by the issuing corporation. Because of its greater degree of safety, a senior security will generally offer lower returns than securities below it in the seniority hierarchy.

Each type of security issued by a company has a specific seniority or repayment ranking, with holders of senior secured bond debt having the privilege of getting paid first, before other security holders. Within this seniority hierarchy, secured bonds, which the issuer has backed with collateral, must be repaid before subordinated or junior bond debt is repaid. After bondholders are repaid, preferred stockholders have repayment seniority over common stockholders.

Common stock, which is the least senior security in a company's capital structure, generally offers investors the highest potential returns to compensate for this additional degree of risk. Common shareholders also have voting rights, while senior security holders do not.

Seniority Bond Ranking

When looking at security ranking, there are several general guidelines.

• Debt ranks higher than equity in the payout order.
• Secured debt ranks higher than unsecured debt.
• Senior debt ranks higher than junior or subordinate debt.

There are several types of bonds. Here's how each would rank in terms of seniority.

• Secured Bonds: These rank the highest in terms of safety and seniority, because they are backed or secured by collateral.
• Senior Bonds: Anything with the title senior attached to it means it ranks higher than junior or subordinate debt.
• Junior or Subordinate Bonds: These are bonds that have a payout ranking that is lower than secured or senior bonds. Junior bonds typically have slightly higher interest payments relative to secured or senior bonds, which have a higher margin of safety.
• Guaranteed or Insured Bonds: These are bonds that are insured or backed by a third party. While they can be quite safe, it is up to the third party to step up and take over the repayment of the bonds in the event the issuing company defaults.
• Convertible Bonds: These securities provide the owner with the option to convert the bond into common stock. This typically isn't a useful feature if the company is in financial distress, and the bonds will be paid out only after all the more senior securities have been paid first.

Investing in Senior Securities

Assume an investor is interested in investing in a company. Buying stock is one way to invest. With this method, the investor can sell out of their position at any time for a profit or loss. They typically have voting rights, but if the company goes into default and the stock price tanks overnight, common stockholders are the last on the list to receive any funds that the company has left.

Another option is to buy preferred shares. Preferred shares don't have voting rights and are much more stable in price since the price of the shares is based on the ability of the company to pay the preferred share dividend. The investor's return is the dividend. Amounts owed to preferred shareholders are paid out before those of common shareholders.

The investor could also buy debt. This includes bonds or commercial paper. In exchange for buying these products, the investor receives interest payments and/or a lump sum back when the paper or bond matures. Interest and principal amounts are paid to investors before preferred shareholders are paid.

Secured or senior debt is another option. With these securities, the investor still receives interest payments and a lump sum back at maturity, but typically the interest is slightly lower than with junior debt since senior debt is considered safer. If the company runs into financial trouble, secured bondholders have access to the collateral that is being held against their position. Senior debt holders get paid first before junior debt holders, preferred shareholders, and common shareholders.

By looking at all the options, an investor can better assess what risk/reward mix they are most comfortable with.