Seniority of Debt: A Beginners Guide

Equities, commodities, derivatives, and fixed income. These are a selection of asset classes an investor may consider while building a diversified portfolio of investments. In line with the opinion of arguably thegreatest investment advisor of the twentieth century, Benjamin Graham who taught and inspired people worldwide (including Warren Buffet). [1] A significant proportion of a risk averse investor’s portfolio is likely to be comprised of fixed income assets namely bonds.  This may be as high as a 75% portfolio allocation in an excessive bull market for the defensive investor. [2] While bonds help mitigate against the risk associated with inflation or the excess volatility of the market. They are not entirely risk free themselves as there is usually a possibility that the institution or company may default. This is where the issuer of the bond is no longer able to meet all its financial obligations i.e. pay owners of the bonds back. The reason for such an event occurring ranges from macro-economic factors including a recession to company specific factors such as poor management or taking on too much debt. However, not all bonds are created equal. During this period, a pre-determine order decides how the remaining capital is paid to investors. This concept is known as seniority. [3]

Seniority Ranking [4]:

1a) Senior Secured Bonds

The ‘senior’ segment of the title refers to the fact that within the secured bond category, these bonds have a higher priority and subsequently are paid first.

1b) Secured Bonds

“Secured” bonds refer to bonds for which the issuer has backed with collateral. [5] This is similar to how a homeowner uses their house as collateral against their mortgage. If a homeowner is unable to pay their mortgage the bank has the authority to enforce a charge on the property. This results in the property being sold and the proceeds being used to cover the debt owed to the bank. Likewise, in the case of default on a secured bond the company sells the asset which they have set aside as collateral (i.e. machinery/buildings). The revenue generated is then used to pay the secured bond holders.

2a). Senior Unsecured Bonds

Similar to point 1a. The ‘senior’ segment in the title refers to the fact that within the unsecured category these bond holders are paid first.

2b) Junior or Subordinated Bonds

After senior debt, junior or subordinated bond holders are paid. As these bonds do not have collateral and are the lowest priority there is no guarantee that these investors will receive their money back. Therefore, it is not uncommon for such bonds to have loss given default (LGD) % of 100. Loss given default is a calculation that anticipates how much of the original investment an investor may lose if the issuer defaults on the loan. Investors typically invest in such bonds if they have a strong credit rating or offer a high yield to compensate for the additional risk taken. [5]

A useful illustration of seniority:

[6]

Debentures (US vs UK)

Debentures are a type of bond which have different meanings depending on geographical location. In the US they typically refer to our category 2 bonds i.e. unsecured and are low priority. However, here in the UK they fall into category 1 which refers to secured bonds. [7].

Bonds in action

A recent active exchange traded fund launched in April 2019 which will traded on the NYSE Arca. Given the recent dovish tone recently displayed by the FED and additional challenges such as an inverted yield curve (time of writing was April 2019). The new Virtus Seix Senior Loan ETF (SEIX) provides one way for investors to gain exposure to the bond market. What makes this ETF interesting is the significant proportion of bonds include first- and second-lien senior floating rate loans i.e. category 1. These senior loans are typically used for business recapitalisations, acquisitions, leveraged buyouts, and re-financings. Such activities are generally seen as riskier. However, due to their seniority and diversification within an ETF it should provide investors with good exposure to this segment of the bond market. [8]

On the other side of the spectrum, last month we also saw Shaw & Co and Caple partner to help SMEs access unsecured debt funding. Small and medium sized companies typically struggle to raise capital without putting up assets as collateral. In addition, due to their unstable cash flows they are often encouraged to raise capital through equity which is expensive as they lose partial ownership of the company. This can have a disproportionate impact on sectors such as fintech, which tend to utilise asset light business models. With this partnership helping to provide long-term unsecured debt finance of between £500,000 and £5 million, it should help boost innovation in SMEs within the UK.