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Investment - Bond Seniority Ranking
The bond indenture offers bondholders the right to take legal action if the issuer fails to fulfill the promised payments or fails to satisfy other requirements mentioned in the contract. If the bond issuer fails to make the promised payments, this failure is referred to as a default and the debt holders often have legal action to reclaim the promised payments. In the case the issuing firm is liquidated, assets are allocated following a priority of claims, or seniority ranking.
This priority of claims can affect the amount that an investment receives at liquidation.
Priority of Claims
The bond indenture offers bondholders the right to take legal action if the issuer fails to fulfill the promised payments or fails to satisfy other requirements mentioned in the contract. If the bond issuer fails to make the promised payments, this failure is referred to as a default and the debt holders often have legal action to reclaim the promised payments. In the case the issuing firm is liquidated, assets are allocated following a priority of claims, or seniority ranking.
This priority of claims can affect the amount that an investment receives at liquidation.
Priority of Claims
The par value (principal) of a bond plus missing interest payments represents the highest amount a bondholder is entitled to collect upon liquidation of a corporation, assuming there are sufficient assets to fulfill the claim. Because debt constitutes a contractual commitment of the corporation, debt holders have a larger claim on a company’s assets than stock holders.
But not all debt holders have the same priority of claim; borrowers may issue debt securities that differ in terms of seniority ranking.
In general, bonds may be issued in the form of secured or unsecured debt securities.
Select the following tabs to learn more about the distinctions between debt securities.
Secured Debt Securities
When a borrower issues secured debt securities, it commits certain specific assets as collateral to the bondholders. As stated in Course 2, Types and Functioning of Markets, collateral is often a tangible item, such as property, plant, or equipment, that the borrower guarantees to the bondholders to secure the loan. In the event of default, the bondholders are legally entitled to take control of the pledged assets.
In effect, the collateral decreases the chance that bondholders will lose money in the case of default because the pledged collateral can be sold to recover some or all of the bondholders’ claim (missing coupon payments and/or recovery of par value).
Unsecured Debt Securities
Unsecured debt securities are not backed by collateral; these bonds are referred to as debentures. Consequently, bondholders will often seek a larger coupon rate on unsecured debt instruments than on secured debt securities. A bond indenture may indicate that an unsecured bond has a lesser priority in the event of default than other unsecured obligations.
A lower priority unsecured bond is termed subordinated debt. Subordinated debt holders receive payment in the case of default only when higher priority debt claims are satisfied in full. Subordinated debt may also be ranked according to priority, from senior to junior.
But not all debt holders have the same priority of claim; borrowers may issue debt securities that differ in terms of seniority ranking.
In general, bonds may be issued in the form of secured or unsecured debt securities.
Select the following tabs to learn more about the distinctions between debt securities.
Secured Debt Securities
When a borrower issues secured debt securities, it commits certain specific assets as collateral to the bondholders. As stated in Course 2, Types and Functioning of Markets, collateral is often a tangible item, such as property, plant, or equipment, that the borrower guarantees to the bondholders to secure the loan. In the event of default, the bondholders are legally entitled to take control of the pledged assets.
In effect, the collateral decreases the chance that bondholders will lose money in the case of default because the pledged collateral can be sold to recover some or all of the bondholders’ claim (missing coupon payments and/or recovery of par value).
Unsecured Debt Securities
Unsecured debt securities are not backed by collateral; these bonds are referred to as debentures. Consequently, bondholders will often seek a larger coupon rate on unsecured debt instruments than on secured debt securities. A bond indenture may indicate that an unsecured bond has a lesser priority in the event of default than other unsecured obligations.
A lower priority unsecured bond is termed subordinated debt. Subordinated debt holders receive payment in the case of default only when higher priority debt claims are satisfied in full. Subordinated debt may also be ranked according to priority, from senior to junior.
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