The first bond is a type of bond that grants the investor a higher priority claim compared to senior bonds when a company files for bankruptcy. Senior bonds typically pay lower interest rates than senior bonds but are repaid before other debts when the company defaults.
Definition and Examples of Senior Bonds
A senior bond is a type of corporate bond that carries a higher priority claim in the event of bankruptcy compared to subordinated bonds, meaning that those holding senior bonds are paid first. Senior bonds are usually unsecured debt; they are not backed by collateral.
To understand senior bonds, you must understand the basics of corporate bonds. When a company needs to raise cash, it often does so by issuing corporate bonds. Investors receive regular interest payments, along with their principal being repaid when the bond reaches its maturity date. However, in the event of default, bondholders take their place in the priority list of the company’s other creditors seeking payment in the event of bankruptcy.
Some senior bonds may be convertible. This means that the senior bond can be converted into shares of the company, giving you the opportunity to own a stake in the company’s equity.
Note: During bankruptcy proceedings, bondholders stop receiving interest payments and shareholders do not receive dividend payments.
Senior Bonds vs. Senior Debt
Although the terms “senior debt” and “senior bonds” are often used interchangeably, they have different meanings. Senior debt typically refers to secured debt, which is backed by collateral such as buildings or equipment.
Senior bonds and subordinated bonds are generally not backed by collateral, which means they are considered unsecured debt. Sometimes, they are referred to as senior notes or subordinated securities.
How Do Senior Bonds Work?
Senior bonds of different types reach their maturity date at different times. It may take up to 10 years for a bond to reach maturity.
The order of repayment of creditors during bankruptcy proceedings is quite complex. However, creditor claims are generally paid according to the following order:
- Secured Creditors: Secured creditors, usually banks, are paid first during a company’s bankruptcy.
- Unsecured Creditors: This category includes banks holding unsecured debt, suppliers, and bondholders.
- Shareholders: Investors who own shares in a bankrupt company are paid last during the liquidation of bankruptcy. There are two types of shareholders, namely common shareholders and preferred shareholders. Shareholders may be left with nothing if secured and unsecured creditors are not fully paid. It is also important to note that preferred shareholders are paid before common shareholders.
Within each category, there is a complex sequential order. For instance, suppliers, customers, and retirees are all considered unsecured creditors. Banks can also hold unsecured debt. This debt may rank equally or higher than the claims of investors holding senior bonds.
Senior bonds are more likely to be repaid than subordinated bonds, which makes them less risky. Due to the lower risk, senior bonds typically pay lower interest than subordinated bonds. However, there is no guarantee that you will be paid in cash. Companies may choose to pay bondholders with shares instead. This depends on the bankruptcy situation and condition.
Note: High-yield bonds, also known as junk bonds, offer higher interest payments because the risk associated with them is higher. Rating agencies like Moody’s, Standard & Poor’s, and Fitch rate bonds according to their creditworthiness. A bond is considered high yield if it has a rating below Ba1 (non-investment grade) from Moody’s or below BB+ from Standard & Poor’s or Fitch.
What
What does this mean for individual investors?
Investing in senior bonds carries less risk compared to junior bonds or stocks, but it is not risk-free. During bankruptcy, investors in senior bonds are paid only after the claims of secured creditors are settled, and other creditors may have higher priority claims.
If you are concerned about default, investing in the senior bonds of one or two companies may not be sufficient to mitigate risk. By investing in a bond fund, you can invest in hundreds or even thousands of bonds. This way, you may reduce risk due to diversification of your investments.
Additionally, the risk of default is not the only risk to consider when investing in any type of bond. Other risks should also be taken into account, whether you are investing in senior or junior bonds, and these include:
- Interest rate risk: Because bond prices are usually inversely related to interest rates, there is a risk that the market value of a bond will decline as interest rates rise.
- Inflation risk: The total yield of a bond may not keep pace with inflation.
- Market risk: The price of a bond may be volatile due to market conditions.
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Sources:
- Office of Investor Education and Advocacy, U.S. Securities and Exchange Commission. “What are corporate bonds?”
- North Carolina State University. “1 Financial Instruments.”
- U.S. Securities and Exchange Commission. “Bankruptcy: What Happens When Public Companies Go Bankrupt?”
- Fidelity. “When Bonds Go Bad.”
- Fidelity. “Bond Ratings.”
- Merrill Edge. “Understanding Bonds and Their Risks.”
Source: https://www.thebalancemoney.com/senior-notes-5190924
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