Senior Debt

What are the Characteristics of Senior Debt?

Senior debt represents the most prevalent form of debt raised by corporates seeking to fund their operations and reinvestments, namely capital expenditures (Capex)

Senior debt financing, often referred to as a “senior term loan”, is traditionally provided by institutional corporate banks or a syndicate (i.e. group of bank lenders).

Notably, senior debt is secured, meaning that the debt issuance is backed by collateral, i.e. the lender now has a lien (i.e. claim) on the assets pledged by the borrower.

The protection provided by the collateral reduces the risk and potential losses incurred by the lender substantially, making senior debt facility terms more favorable to the borrower.

By virtue of possessing the highest claim on the company’s assets – i.e. placement at the top of the capital structure – senior debt carries the least risk.

Hypothetically, in the event of bankruptcy (or liquidation), senior debt lenders hold seniority above all other stakeholders (including other lenders).

Therefore, senior lenders are the most likely to receive full recovery of the original capital provided, even if the borrower were to default and become insolvent.

What is the Interest Rate on Senior Debt?

Usually, senior debt is priced at the lowest interest rate compared to riskier types of debt instruments, i.e. unsecured debt capital.

Like most financing instruments, the borrower is contractually obligated to pay interest to the lender periodically across the borrowing term, as well as repay the entire principal amount on the date of maturity.

• Secured Debt → Lower Interest Rate + Favorable Lending Terms to Borrower
• Unsecured Debt → Higher Interest Rate + Less Favorable Lending Terms to Borrower

Since the financing is secured by the borrower’s assets, the collateral can be seized by the lender in the case of default (i.e. due to a missed interest payment or if the borrower cannot repay principal) or a covenant breach.

The drawback, however, is that traditional bank lenders tend to be the most risk-averse (and there is a limitation as to how much senior debt can be raised).

Moreover, the interest expense owed on senior debt is most often priced at a floating rate against a specified benchmark rate such as SOFR (formerly LIBOR), as opposed to a fixed rate.

• If interest rates are expected to fall in the near-term future, investors prefer fixed interest rates.
• If interest rates are expected to increase, investors would prefer floating interest rates.

What are the Different Types of Senior Debt?

The chart below describes the most common types of senior debt.

Senior Debt vs. Subordinated Debt: What is the Difference?

The pricing of debt, or interest rate charged, is a function of its placement on the capital structure.

The difference between senior and subordinated debt is that the former takes precedence in the event of default (or bankruptcy), as its claims are more senior.

In such scenarios, such as bankruptcies, the senior claims recoup their losses before the subordinated claims can be paid back.

As such, senior debt is perceived as the cheapest source of financing because of the secured nature of the financing, i.e. senior debt carries the lowest cost of debt relative to “riskier” tranches of debt.

While the interests of senior lenders are protected by the pledged collateral, unsecured lenders are not afforded the same type of protection (and thereby, the recoveries in the event of default are lower).

Unlike senior lenders, subordinate lenders that provide riskier types of financing, such as mezzanine financing, charge higher interest rates, which are generally priced at a fixed rate. Since they bear higher risk, they are compensated via higher returns (i.e. interest rates).

• Subordinated Lenders → A fixed rate is established to ensure the lender receives a sufficient return (i.e. the “target yield” is met).
• Senior Lenders → In comparison, senior debt lenders such as traditional banks prioritize capital preservation and minimizing losses above all else.

Further, senior debt can usually be paid back early with no (or minimal) prepayment fees, while subordinated lenders charge higher penalties in the case of prepayment.

What are Covenants in Senior Debt Financing?

In the next section, we’ll discuss debt covenants, which are implemented in the loan agreement by senior lenders to further protect their downside risk.

Debt covenants are legally binding obligations agreed upon by all relevant parties that require the borrower to be in compliance with a specific rule or when taking a specific action (and historically have been tied to senior lenders more than subordinate lenders).

• Affirmative Covenants → Affirmative covenants, or positive debt covenants, state certain obligations that the borrower must fulfill in order to remain in good standing with loan agreement terms.
• Restrictive Covenants → Restrictive covenants, or negative debt covenants, are conditional measures intended to prevent borrowers from taking high-risk actions that place repayment at risk without prior approval.
• Financial Covenants → Financial covenants are pre-determined credit ratios and operating metrics that the borrower must not breach, such as a minimum leverage ratio.

Financial covenants can be separated into two distinct types:

• Maintenance Covenants → Maintenance covenants, as implied by the name, require the borrower to maintain certain credit ratios and metrics to avoid violating the covenant, e.g. Leverage Ratio < 5.0x, Senior Leverage Ratio < 3.0x, Interest Coverage Ratio > 3.0x
• Incurrence Covenants → Incurrence covenants are tested for compliance only if the borrower has taken a specific action, i.e. a “triggering” event, rather than being tested regularly.

Covenants can be a significant drawback to borrowers, as the provisions can be restrictive in terms of limiting a company’s ability to perform (or not perform) certain actions – which reduces the operating flexibility of the company.

Senior lenders have, however, become more lenient on debt covenants and now the term “covenant-lite” has become common, which stems in part from the low-interest rate environment and increased competition in the lending market, i.e. the number of lenders in the market has increased due to the entrance of direct lenders (and the emergence of unitranche terms loans).

Given current market conditions, i.e. high risk of an economic contraction, long-lasting recession, record high inflation, etc., more strict covenants could soon return to the credit markets.