Ranking of notes: Overview, definition, and example
What is the ranking of notes?
Ranking of notes refers to the order of priority in which different types of debt securities (notes) are repaid in the event of liquidation, bankruptcy, or other financial restructuring. In simpler terms, it determines which creditors get paid first and which creditors are paid last when a company is unable to meet all of its financial obligations.
In debt markets, notes are typically classified into different ranks or tiers, such as senior, subordinated, and junior. Senior notes have the highest priority and are paid first, while subordinated or junior notes are repaid only after the senior debt is fully satisfied. The ranking structure is typically outlined in the terms of the debt agreement, which provides a clear hierarchy of repayment for creditors.
Why is ranking of notes important?
The ranking of notes is important because it directly impacts the risk and return of each type of debt investment. Senior debt is considered less risky because it is paid before other types of debt in case of financial trouble, and therefore, senior notes usually offer lower interest rates. On the other hand, subordinated or junior debt is riskier because it is paid last, after senior obligations have been met, so it typically carries higher interest rates to compensate for the additional risk.
For investors, understanding the ranking of notes helps assess the level of risk associated with an investment and determines the likelihood of receiving repayment in the event of the borrower’s default or bankruptcy. For the borrower, the ranking of notes helps structure their financing in a way that balances their needs for capital with the cost of borrowing.
Understanding ranking of notes through an example
Imagine a company, ABC Corp., that issues two types of debt: senior notes and subordinated notes. ABC Corp. goes into bankruptcy, and the creditors are seeking repayment.
- Senior notes: These are the first to be repaid. If the company has enough assets to cover its debts, the senior noteholders will be paid in full before any other creditors receive payment.
- Subordinated notes: These are repaid only after the senior debt is satisfied. If there are remaining funds after the senior creditors are paid, the subordinated noteholders may receive payment, but they are last in line.
For example, if ABC Corp. has $10 million in assets but owes $15 million in debt (with $5 million in senior notes and $10 million in subordinated notes), the senior noteholders will be paid the full $5 million first. The subordinated noteholders will not receive anything because the total assets are insufficient to cover their portion of the debt.
Example of ranking of notes clause
Here’s how a ranking of notes clause might appear in a debt agreement:
“In the event of liquidation, bankruptcy, or any other form of financial restructuring, the Notes issued under this Agreement shall rank as follows: (i) the Senior Notes shall rank first in priority and be paid in full before any other debt obligations, (ii) the Subordinated Notes shall rank after the Senior Notes and be paid only after the Senior Notes have been satisfied, and (iii) the Junior Notes shall rank last in priority and be repaid only after all other debts, including Senior and Subordinated Notes, have been fully satisfied.”
Conclusion
The ranking of notes is a crucial concept in debt financing, as it determines the order in which creditors are repaid in case of financial distress. Understanding the ranking helps investors assess the risk of their investment and the likelihood of receiving repayment. For borrowers, structuring the ranking of notes appropriately can help balance the need for capital with the cost of borrowing, and ensure that they meet the obligations to various creditors in an orderly manner.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.