What is a Senior Security?
Senior security refers to those financial instruments issued by a corporation that receive priority status for payment, in the event of liquidation or dissolution of the company. The capital structure of most publicly-held companies consists of a mix of debt and equity securities. A typical corporate configuration might include various bonds — or debt obligations of different maturities, or due dates — and preferred, as well as common, stock. The priority status for most securities issued by a corporation can be ranked according their seniority in ascending order as follows: debt securities, preferred stock, and lastly, common stock.
Unlike common stockholders who own a business enterprise, bondholders are creditors of a corporation. A corporate bond is denoted as a senior security because the company is legally obligated to pay annual interest to the holders of these securities and, when the bonds mature or come due, the principal amount of the bond must be repaid. In the event of bankruptcy liquidation, preferred and common stockholders of a corporation are paid only after all the claims of bondholders have been satisfied.
Many corporations issue various classes of senior securities, ranked according to the preference afforded each, in the event of liquidation. Some bonds issued by a corporation are backed, or collateralized, by the physical assets of the company. Certain bonds, or debentures, issued by a company may also be classified as either subordinated or unsubordinated. Though they may still be considered as senior securities in relation to the claims of a corporation’s preferred and common stockholders, subordinated bonds are junior, or subordinate, to the claims of the holders of its unsubordinated debt securities.
Generally, when they purchase a senior security issued by a corporation, investors will demand a rate of return commensurate with the risk assumed. The particular annual interest rate a company must pay on a bond issue will depend on how subordinated the bond is to the other senior securities previously issued. In general, bonds with a lower priority status must pay a higher interest rate in order to compensate investors for the additional risk. Often a contract or indenture agreement between a corporation and its senior unsubordinated bondholders requires the company to maintain seniority status. Any subsequent issue of debt securities by the corporation would be junior to the claims of these unsubordinated bondholders.
Preferred stock issued by a corporation is often characterized as a senior security. In the event of a corporate liquidation, preferred shareholders have payment priority over common stockholders. In addition, a company must first pay dividends to preferred shareholders before any dividends can be paid on its common stock.
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