Bond Seniority

When a company fails, there’s often not enough money to pay everyone. Seniority determines who gets paid first. Senior bonds are paid before subordinated bonds. Secured bonds are paid before unsecured ones. This ranking is written into the bond indenture and dramatically affects the risk—and hence the yield—you should demand.

The seniority ladder

In a company’s capital structure, claims on assets stack in a specific order:

1. Secured senior debt. Bonds backed by specific assets (machinery, real estate, accounts receivable). In bankruptcy, these bondholders seize the collateral first.

2. Unsecured senior debt. General corporate bonds with no collateral but a senior claim on remaining assets after secured lenders are paid.

3. Subordinated debt. Bonds explicitly junior to senior debt; they’re paid only after senior creditors are satisfied.

4. Preferred stock. A hybrid security ranking above common equity but below all bonds.

5. Common stock. The residual claim; equity holders get whatever is left, which is often nothing in bankruptcy.

Employees, suppliers, and taxing authorities have claims at various points too, but bonds typically focus on the senior-to-subordinated hierarchy.

Why seniority matters in default

Here’s a concrete example. A company goes bankrupt with $100 million in assets. Its capital structure:

• $30 million in secured senior debt (mortgage on real estate)
• $40 million in unsecured senior debt
• $20 million in subordinated debt
• $50 million in equity

The liquidation proceeds are $80 million (assets sold for less than book value). Here’s what happens:

• Secured senior gets $30 million (from the mortgaged assets).
• Unsecured senior gets $40 million (their full claim, paid from remaining $50 million).
• Subordinated gets $10 million (the $20 million claim is cut to $10 million—50 cents on the dollar).
• Equity gets $0 (nothing left).

This is why subordinated bonds yield more than senior bonds—there’s less assurance of full recovery.

Seniority in bond covenants

The indenture often restricts the company from issuing debt senior or pari passu (equal in rank) to existing bonds without bondholder consent. This protects current bondholders from dilution of their seniority status. A company might promise: “We won’t incur senior debt unless it stays below 50% of EBITDA.” This constraint makes subordinated debt cheaper for the company to issue because investors know the subordinated layer won’t be swamped by new senior debt.

Seniority and credit ratings

Credit rating agencies factor seniority heavily into ratings. A junk-rated company’s subordinated bonds might be rated CCC, while its senior unsecured bonds are B–. The rating reflects not only the probability of default but also the expected recovery given default. Senior bonds recover more, so they’re rated higher for the same issuer.

Secured vs. unsecured

Secured senior bonds are backed by pledged collateral—factories, equipment, real estate, cash flow from operating contracts. If the company defaults, the secured bondholders can foreclose and sell the collateral. This dramatically lowers their loss in default, so secured bonds typically yield less than unsecured. However, secured bonds are less common in the corporate bond market—most corporate borrowing is unsecured. Secured debt is more common in asset-backed vehicles and project finance.

Cross-default and rating cascades

A company’s seniority structure is tested in stress. In a debt restructuring, senior creditors often preserve more of their claims while subordinated creditors take larger haircuts. If senior bondholders agree to extend maturities or cut coupons, subordinated holders usually must accept harsher terms. This is why subordinated bonds are riskier—in a workout, they’re last in line to negotiate.