Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Junior Security

What it is:

A junior security is subordinate to other securities issued by a company.

How it works (Example):

For example, if Company XYZ issues preferred stock, the shareholders of that stock are senior to Company XYZ's common stock shareholders. This means that should Company XYZ go bankrupt, the preferred shareholders are entitled to repayment before the common shareholders. The common stock is therefore the junior security.

Let’s say Company XYZ needs more capital now, so it borrows money from Bank ABC. Who gets paid first now? The bondholders or Company XYZ? It depends on what Company XYZ negotiates with Bank ABC, but it is likely that Bank ABC is now holding junior, meaning that if Company XYZ goes belly up, the bondholders get paid first, then Bank ABC, then the shareholders (if there’s anything left).

Why it Matters:

Owners of senior securities get their hands on leftover cash before others in the event of bankruptcy. Accordingly, lenders of junior debt (those lenders further down in the pecking order) are more likely to get stiffed. This is why some lenders might require senior status in order to make a loan (meaning that they must be first in line). In our example, Bank ABC may charge a higher interest rate on the loan because of its subordinated status and thus added risk of not being able to get its hands on any of the scraps if Company XYZ goes bankrupt.

The more subordinate a creditor, the weaker its claim on the company's assets. The weaker this claim, the higher the risk that the creditor will be left with nothing if the borrower defaults. This is why the more junior a security is, the higher the return investors demand.