Junior Security

What Is a Junior Security?

The term junior security alludes to a security with a lower priority than others. Put just, junior security is subordinate to some other type of security. This means that junior security holders get compensated solely after the individuals who own senior securities if and when a company fails or is liquidated. Thusly, there's a generally excellent chance that some (or even every one) of the junior securities to which a company owes money may not be repaid after any extra cash is distributed.

Grasping Junior Securities

At the point when a company declares bankruptcy or is liquidated, all stakeholders in the company need to be repaid however much of their investment as could reasonably be expected. In any case, there are clear rules in place that determine the seniority of various securities. This means that the order where various types of partners are repaid is predetermined, where some are senior securities and others junior.

Junior securities incorporate those like common stock. As noted before, these securities fall lower on the priority scale with regards to repayment. Senior securities end up at the first spot on the list and are viewed as the most secure types of securities. This permits holders of these securities to be paid before any others. The most common types of senior securities are generally bonds, debentures, bank loans, and preferred shares.

Repayment relies upon the company's capital structure. In bankruptcy cases secured and unsecured creditors are paid from the company's assets before stockholders. Bondholders and lenders of secured debt are normally repaid first. Cash is split between senior securities before any junior holders are paid out. In certain cases, a few common shares might get some money back, while others may not be repaid by any stretch of the imagination.

There's an excellent justification for why a few securities are focused on over others: Not all securities have the equivalent risk-reward profile. For example, corporate bondholders might hope to receive an interest rate of 3.5% in the present market, though shareholders can hypothetically acquire unlimited upside potential and dividend payments. Bondholders must be compensated as lower risk in light of the unassuming returns associated with corporate bonds. Thusly, they are given priority over shareholders assuming that the responsible company ever defaults.

The method of ordering asset repayment in the event of bankruptcy is known as the principle of Absolute Priority. In light of Section 1129(b)(2) of the U.S. Bankruptcy Code, it is in some cases alluded to as the principle of liquidation preference.

Illustration of a Junior Security

Here is a speculative guide to show how junior securities work. Suppose you own a manufacturing company called XYZ Industries. To send off your company, you raised $1 million from shareholders and took out a $500,000 mortgage to buy real estate for your factory. You then, at that point, secured a $500,000 credit extension from the bank, to fund your working capital requirements.

You see that you have maximized your credit extension and have an outstanding balance of $350,000 on your mortgage subsequent to taking a gander at your balance sheet. After liquidating the entirety of your equipment and different assets, you raise a total of $900,000.

You want to pay out your senior creditors first, to be specific the bank that loaned you the mortgage and the credit extension. Of the $900,000 you raised from selling your assets, $350,000 pays off the mortgage and $500,000 goes to the credit extension. The leftover $50,000 is distributed to your investors, who are last in line since they invested in common shares, which are junior security.

Albeit this addresses an extremely severe 95% loss for your shareholders, recall that in the event that your business had been effective, there could be no upper limit to the return on investment (ROI) they might have delighted in. That is the risk they assumed when they invested in your business.

Features

• Junior securities have a lower priority of claim on assets or income compared to senior securities.
• Junior security holders carry greater risk since they may either receive some or none of their investment back on account of default.
• Common shares are forms of junior securities while bonds are considered senior securities.
• After senior securities are paid, any extra cash is split between junior security holders.
• In normal conditions, junior security holders partake in a greater reward than other, more senior issues.