To understand senior and subordinated debt, it is important to understand the role of debt in the capital markets and how bond investors analyze, market and sell debt investments. In the investment and business world, debt comes in the form of bonds. When a company or government agency needs to borrow money, it may do so by issuing bonds. When a business or government entity borrows money from investors by issuing bonds, it is responsible for paying back the loan via regular interest payments and the repayment of principal on schedule. Sometimes, though, these entities get into trouble and can't make the payments.
Senior vs. Subordinated
When the company, government agency or entity that issued the bond gets into trouble, the issue of senior debt vs. subordinated debt becomes important. Generally, when a company or government agency can't pay its bondholders, it defaults and may go into bankruptcy. Court officials then direct the assets of the company to pay off creditors in a specific order. Senior debts get paid off first; subordinated debt holders get paid with what is left over.
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Secured vs. Unsecured Debt
Generally, senior debt is also secured debt, while subordinated debt is unsecured debt. That is, the debt has not been secured through the pledging of any kind of specific collateral. Unsecured debt is issued simply on the good name of the borrower and faith that the future cash flows will be adequate to pay off bondholders. By law, companies must pay off bondholders prior to issuing a dividend to stockholders.
Risk and Compensation
Because subordinated debt falls below senior debt in the order of priority in the case of default, bonds issued as subordinated debt generally have higher interest rates than senior issues. Note that the term "senior" does not refer to the chronological order of issuance; only to its status as higher in the bankruptcy order of priority than subordinated debt.
Often, investment banks will purchase huge blocks of mortgage pools, credit card accounts receivable or other form of debt. These are called "asset-backed" securities. They will then break up the debt in "tranches," some of which will receive higher ratings, others of which will receive lower ratings. If there are defaults in the pool, they will be assigned first to the lower-rated tranches. They then sell off pieces of the pool in various tranches to investors. Those seeking a safe place to earn modest returns will buy the higher-rated tranches. Those hoping to earn a higher interest rate and who are more willing to accept risk may choose the lower-rated tranches.