What is Junior Tranche (Subordinated Debt)?
A junior tranche is a type of debt that is unsecured and considered riskier but the same pay a high rate of interest and it is the first that absorbs any losses accrued or earned on the value of securities and it is also called mezzanine tranches.
Junior Tranche (Debt) -For that, we will separate these two words – junior and tranche.
- The word “tranche” is used in structured finance. “Tranche” is a French word. And it means “slice,” “portion.”
- So, if we add junior to tranche, we would get the meaning of the lowermost tranche of security. That means when we talk about junior tranche; we talk about the lowest tranche.
This lowest tranche is the riskiest. And at the same time, it pays the highest rate of interest as it accepts the most risk.
If there’s any loss on the value of the security, the junior tranche is the first to absorb it.
Junior tranches are also termed as mezzanine tranchesMezzanine TranchesMezzanine financing is a type of financing that combines the characteristics of debt and equity financing by granting lenders the right to convert their loan into equity in the event of a default (only after other senior debts are paid off).. If we compare the total value of the security with the value of junior tranches, junior tranches account for only 10-20%.
Why do you need to know about Junior Tranche?
As an investor (shareholder), you need to know about junior tranches to understand how you will get paid and when. The junior tranche is a subordinated portion of the debt, and it is unsecured too. Thus, the risk is much higher, and the chance of repayment only comes after repaying the senior debt holders.
Let’s understand this with an example.
Let’s say that a company files for bankruptcy. And let’s say the name of the company is M Company. Now, as M Company files for bankruptcy, the company would go into liquidation, and its creditors will get paid in order of preference.
At this stage, there are two debt creditors – senior debt creditors and junior debt creditors (junior tranche).
After the liquidation of the Company M, senior debt holders will be paid first. If there’s anything left after paying the senior debt holders, the junior tranche will be paid next.
Since the risk of the junior tranche is much higher than the senior debt holders, to compensate for the risk, the junior tranche receives a higher interest rate.
You may think why junior tranches take so much risk when the chances of payment are always bleak.
It’s because when they get paid, they get paid well, and they get paid even before the shareholders of the company. Plus, before they ever invest in a company, they do their own due diligence. And if they see that the company doesn’t have enough resources to pay off the senior debt holders, they abstain from investing in that particular company.
How junior debt holders do their due diligence?
The obvious question is when there are so much risk and so little chance of getting paid, how junior debt holders do their due diligence.
- The first thing they look at before they ever invest in a company is the total assets. If the total assets of a company are huge, after liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order., they would easily get paid. If the total assets of the company are not so huge, they avoid investing in the company. Looking at the total assets of the company is their first filter.
- The second thing they look at the total liabilities. If the total liabilities are almost similar to the total assets (we keep the shareholders’ equity aside), then it’s not a good deal for junior debt holders. But for senior debt holders, this can be a pretty good deal.
- Plus, the junior debt holders look at all other financial ratios of the companyFinancial Ratios Of The CompanyFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. to make sure that they’re investing in the right company, and their chances of success are higher.
Where is junior debt recorded on the balance sheet?
As you already know, junior tranches are paid off after the senior debt. Obviously, it would be recorded in the liability section.
Here’s how it is being recorded.
- In the liability section of the balance sheet, first, current liabilities Current Liabilities Current Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.are recorded.
- After the current liabilities, the long-term liabilities are recorded.
- Under the long-term liabilities, the senior debts are recorded first since they would be paid off first in the case of bankruptcy. After recording the senior debts, junior debts are recorded.
Why are Junior Tranches used?
You may think when the interest rate is so very higher for a company to take junior debt, why do they use it?
It is because the alternative is not so prudent to do in terms of the company’s perspective. They can issue new sharesIssue New SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. to the public, but this will dilute the ownership of the company. Thus, even if the junior debt isn’t a preferred option for a company, it’s way better than issuing new shares to the public.
This has been a guide to Junior Tranches, important features of Junior Tranches, how it is recorded in the balance sheet, and why they are used. You may also have a look at other articles on Fixed Income –