Debt Seniority

Debt seniority is the ranking that decides which creditors get paid first when a borrower cannot pay everyone in full, usually in bankruptcy, liquidation or a restructuring. Senior debt has the first claim on the borrower's assets; junior or subordinated debt is paid only after senior claims are satisfied; and shareholders, as owners, come last. Seniority is set by contract, by security over assets and by insolvency law.

Because it determines how much each lender can expect to recover after a default, seniority is one of the main drivers of the interest rate a lender demands and of the credit spread on its bonds. Senior secured loans are the safest claims on a company's debt and pay the least; subordinated bonds and mezzanine loans pay more to compensate for being further back in the queue. The same idea shapes the tranches of securitized products, the capital stacks of leveraged buyouts and the loss-absorbing debt that banks must hold.

Picture a queue outside a shop that is closing down and selling what is left. The people at the front of the queue are served first and usually get everything they came for. Those further back may get only part of what they wanted, and the people at the very end may leave empty-handed.

Debt seniority is that queue for a failed business. Lenders agree in advance where they will stand. Those willing to stand further back, and accept a higher chance of getting little or nothing, are paid a higher rate of interest for taking that place.

A typical corporate capital structure, from first to last claim, looks like this:

1. Senior secured debt. Bank loans and bonds backed by specific collateral, such as property or receivables. First-lien lenders rank ahead of second-lien lenders on the same assets.
2. Senior unsecured debt. Most investment-grade corporate bonds and many Eurobonds, with a general claim on assets not pledged to others.
3. Subordinated debt. Bonds and notes whose terms place them behind senior debt, often issued by banks or as part of buyout financing.
4. Mezzanine and hybrid capital. Deeply subordinated debt and instruments with equity-like features.
5. Preferred stock. Equity with a priority over ordinary shares for dividends and liquidation proceeds.
6. Common stock. Ordinary shareholders, who receive whatever is left, which in a real failure is often nothing; thanks to limited liability, they lose no more than their investment.

Insolvency laws also give some claims statutory priority, such as the costs of running the bankruptcy, certain employee wages and certain taxes. In the UK, for example, HM Revenue and Customs became a secondary preferential creditor for some taxes from December 2020.

Suppose a company is wound up and its assets raise 100 million after costs. It owes 50 million to secured lenders, 40 million to senior unsecured bondholders and 30 million to subordinated bondholders.

If the assets had raised only 70 million, the secured lenders would still be paid in full, the senior unsecured holders would get half, and the subordinated holders nothing. This is why credit ratings are often notched lower for junior debt of the same issuer, and why high-yield bonds are frequently subordinated.

Real outcomes are messier than the textbook order. In the United States the absolute priority rule says a junior class should receive nothing until senior classes are paid in full, but negotiated Chapter 11 plans sometimes give junior creditors or even shareholders a small recovery to secure agreement. Rating agency studies of defaults have generally found much higher average recoveries for first-lien loans than for senior unsecured bonds, with subordinated bonds recovering least.

Two further forms of ranking matter:

• Structural subordination. Creditors of a holding company rank behind creditors of its operating subsidiaries, because the holding company owns only shares in those subsidiaries, which sit at the bottom of each subsidiary's own queue.
• Contractual subordination. Intercreditor agreements can rearrange priorities between lenders, a common feature of private credit and buyout deals.

Securitization applies the same logic to pools of loans. Senior tranches of collateralized debt obligations and mortgage securities are paid first from incoming cash, while junior tranches absorb the first losses.

After the 2008 financial crisis, regulators sought to make bank creditors, rather than taxpayers, absorb losses. Under Basel III and resolution regimes such as the EU's Bank Recovery and Resolution Directive, banks must issue loss-absorbing debt that can be written down or converted to equity in a set order, starting with shareholders, then Additional Tier 1 and Tier 2 instruments, then senior debt. In March 2023 the Swiss supervisor FINMA ordered about CHF 16 billion of Credit Suisse's Additional Tier 1 bonds to be written off as part of its takeover by UBS, while shareholders received UBS shares. The decision, permitted by the bonds' terms and Swiss emergency law, was criticised for appearing to reverse the usual hierarchy and led to lawsuits.

Governments have no bankruptcy court. In a sovereign default most private bonds rank equally under pari passu clauses, while the IMF and other multilateral lenders are treated by convention as preferred creditors, paid ahead of private bondholders.

• United States Courts: Chapter 11 bankruptcy basics
• Financial Stability Board