What is Junior Debt?
In the event of a borrower’s bankruptcy, junior debt is debt that is repaid after the obligations to senior lenders or creditors have been fulfilled. Usually, it also has no collateral.
How Does Junior Debt Work?
For example, if Company XYZ issues bonds, the bondholders are creditors who are senior to Company XYZ's shareholders, for example. This means that should Company XYZ go bankrupt, the bondholders are entitled to repayment before the shareholders are.
Let’s say that Company XYZ needs more capital now, and so it borrows money from Bank ABC. Who gets paid first if Company XYZ goes bankrupt? The bondholders or Company XYZ, or the bank? It depends on what Company XYZ negotiates with Bank ABC, but it is likely that Bank ABC is now holding junior debt, 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 Does Junior Debt Matter?
Senior lenders get their hands on leftover cash first 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, possible lack of collateral, and thus added risk of not being able to get its hands on any of the scraps if Company XYZ goes bankrupt.