Junior TrancheWhy does debt position matter as an investor?

Lisa Borga

A junior tranche, also known as a mezzanine tranche, is a segment of a pool of securities that are ranked lower in repayment priority than other tranches should a default occur.

As a risk, a junior tranche is deemed to be riskier than an investment in senior tranches, which receive higher priority for repayment.

However, in order to encourage investors to accept this higher degree of risk, the junior tranche often pays a higher rate of interest.

Understanding Junior Tranche Debt

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When debt is issued, it may be categorized as subordinated (junior) or unsubordinated (senior) debt.

As an investor, it is important to understand the difference between the two because this will determine when and how you will be repaid.

The difference between these two categories becomes most important if and when a company is unable to repay its creditors.

When a company is unable to pay its creditors and chooses to file for bankruptcy, a court may choose to appoint a liquidator in order to sell the company’s assets to repay its creditors.

Any funds raised by this liquidation will be distributed to creditors in the order of their priority.

The highest priority creditors will be those that hold unsubordinated or senior debt.

Only after these creditors have been repaid will subordinated, or junior debt holders receive any payments.

Because the senior debt holders will receive payment in full before junior debt holders receive any payments, the proceeds from a liquidation may not be sufficient to make full payment on their debts.

Further, these junior debt holders face a much higher risk that no funds will be remaining at all by the time that senior debt holders have received payment in full.

However, junior debt holders will only be able to begin collecting payments from the liquidation of assets after senior debt holders are paid, but they will be paid before shareholders.

A company’s shareholders can only begin to collect on debts if there are funds remaining after both senior and junior debt holders have received payment in full.

Because of the higher risk involved in investments in junior debts or tranches, investors should always ensure that they have thoroughly examined and considered whether a given company is likely to be able to meet its obligations.

If a company were to file for bankruptcy and face liquidation of its assets, junior debt holders would not be first in line to receive payments; therefore, there is a risk that there will be insufficient funds to repay these investors.

Before investing in a junior tranche, an investor should determine the amount of assets that a company holds as well as its total debts and whether the company has a suitable cash flow to meet its obligations.

Additionally, for investors seeking investments with a lower risk, it may be wise to consider investing in a senior tranche.

In all types of credit, repayment seniority plays a crucial role in determining the risk and potential benefits involved.

When a debt is issued, it may be designated as a senior or a junior debt or tranche.

A senior tranche will receive the highest priority for repayment in the event of a default or liquidation and generally will be secured with collateral, though this is not always the case.

A junior tranche will only receive payment after all senior debt holders have been repaid and are not secured with collateral.

Though a junior tranche possesses a high risk, it also offers the highest potential returns.

In order to encourage investment, junior tranche investments offer a higher interest rate than senior tranches.

Most institutional investors favor senior tranche debt due to the greater security that it offers against loss.

However, many investors with significant holdings in a given company as well as parent companies will accept junior tranche investments from a given company due to their familiarity, which makes them willing to accept the greater risks associated with such an investment.

These investors may also be willing to accept a lower interest rate for the debt due to their relationship with the company.

Often these investors may accept a lower rate of return than outside investors would be willing to allow companies in a poor financial position, thus allowing the companies time to recover.

How Junior Tranches Are Repaid

When debt is issued, it may be categorized as subordinated (junior) or unsubordinated (senior) debt.

As an investor, it is important to understand the difference between the two because this will determine when and how you will be repaid.

The difference between these two categories becomes most important if and when a company is unable to repay its creditors.

When a company is unable to pay its creditors and chooses to file for bankruptcy, a court may choose to appoint a liquidator in order to sell the company’s assets to repay its creditors.

Any funds raised by this liquidation will be distributed to creditors in the order of their priority.

The highest priority creditors will be those that hold unsubordinated or senior debt.

Only after these creditors have been repaid will subordinated, or junior debt holders receive any payments.

Because the senior debt holders will receive payment in full before junior debt holders receive any payments, the proceeds from a liquidation may not be sufficient to make full payment on their debts.

Further, these junior debt holders face a much higher risk that no funds will be remaining at all by the time that senior debt holders have received payment in full.

However, junior debt holders will only be able to begin collecting payments from the liquidation of assets after senior debt holders are paid. A company’s shareholders can only begin to collect on debts if there are funds remaining after both senior and junior debt holders have received payment in full.

Because of the higher risk involved in investments in junior debts or tranches, investors should always ensure that they have thoroughly examined and considered whether a given company is likely to be able to meet its obligations.

If a company were to file for bankruptcy and face the liquidation of its assets, junior debt holders would not be first in line to receive payments; therefore, there is a risk that there will be insufficient funds to repay these investors.

Before investing in a junior tranche, an investor should determine the amount of assets that a company holds as well as its total debts and whether the company has a suitable cash flow to meet its obligations.

Additionally, for investors seeking investments with a lower risk, it may be wise to consider investing in a senior tranche.

How To Record Junior Debt on the Balance Sheet

A business’s assets are listed on the balance sheet first.

After the assets, the liabilities are listed, and then the stockholders’ equity.

Junior debt will be listed as part of liabilities since it is money that the business has borrowed.

The liabilities section of the balance sheet will have current liabilities listed first and then long-term liabilities.

Senior debt will be listed in the long-term liabilities section first, and then junior debt.

This is because long-term liabilities are listed based on priority.

The debt that will be paid first should the company be liquidated is listed first, followed by the remaining debts in the order they are to be paid.

If a company sells bonds as part of subordinated debt, the proceeds the company receives as cash will be recorded in current assets in the cash account.

However, if the company buys equipment or property with the funds, it will be recorded with long-term assets on the balance sheet.

How Do Junior Debt and Senior Debt Differ?

Here are some of the ways in which junior debt and senior debt differ.

Payment Times

Senior debt is typically expected to be repaid sooner than junior debt.

The principal and interest payments on senior debt are typically paid to lenders earlier than the principal and interest for junior debt.

Interest Rates

When an investor invests in riskier forms of debt, there is a greater risk of default.

Therefore, a higher rate of interest is generally provided to compensate for the risk.

Because of this, investors holding junior debt are generally paid a higher rate of interest than those holding senior debt.

Senior debt holders can earn anywhere from 225 to 325 basis points. In contrast, junior debt holders are more likely to earn margins of approximately 800 to 1000 points.

Senior debt holders generally receive interest payments that are lower than other creditors due to the fact that they receive priority in payments if the company is liquidated.

If the company is liquidated, once the assets are all sold, and the money is collected, senior debt holders are paid first.

Security

Both junior and senior debt is paid before ordinary stockholders receive any money.

Holders of senior and junior debt are paid based on priority from any cash received from liquidating assets.

An inter-creditor agreement formed by the business’s creditors determines the order in which creditors are paid.

An inter-creditor agreement is formed when one creditor is willing to agree to be subordinate to another creditor when payments of principal are being made.

Generally, senior debt is paid first, then junior debt next. After this, other creditors are paid.

Why Do Companies Issue Junior Tranches?

Junior debt is commonly used to provide capital growth, finance acquisitions, fund leveraged buyouts, or for funding recapitalization.

This type of debt is also sometimes combined with preferred stock, which forms a hybrid security.

This then pays the holder dividends, which are funded by the business issuing the security as interest expense.

Companies generally do not see issuing junior debt as ideal due to the high-interest rates they must pay.

However, they often prefer using junior tranches to issuing new shares because issuing new shares will dilute the company’s ownership.

Key Takeaways

  • A junior tranche is a form of unsecured debt with a lower priority for repayment relative to more senior tranches. This means that it has a higher risk for loss than senior tranches.
  • A junior tranche debt typically offers higher interest rates to compensate investors for the higher risk of loss.
  • A junior tranche is a form of subordinated debt which means that repayment will only be made to these debt holders after more senior debt holders.

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