Senior Notes

Senior notes are debt securities, or bonds, that take precedence over other unsecured notes in the event of bankruptcy. Senior notes must be paid first if assets are available in the event of a company liquidation. A senior note pays a lower coupon rate of interest compared to junior unsecured bonds, since the senior debt has a higher level of security and a reduced risk of default.

Unlike senior debt, senior notes are not necessarily backed by specific assets pledged as collateral, which means that the bondholder may not receive his full principal and interest in the event of liquidation. If a liquidation occurs, secured debt is repaid first by selling the collateral backing the debt, then senior notes are paid, followed by other unsecured debt holders.

Senior notes typically have shorter maturity time periods than bonds. Corporations issue senior notes with maturities of 10 years or less. Municipal bonds, on the other hand, categorize senior notes as having one year or less to maturity, and U.S. Treasury notes mature in two to 10 years.

Standard & Poor's and Moody's Investors Service are the two largest firms that provide bond ratings, which are based on the issuer's ability to repay the principal and the interest payments on time. The rating for a senior note is based on the creditworthiness of the issuer, including the ability to generate consistent earnings to finance debt payments. A common formula to analyze creditworthiness is the interest coverage ratio, or the ratio of earnings before interest and taxes divided by interest expense. This ratio documents how much in earnings the company generates as a multiple of interest expense. A larger ratio means that the firm generates more earnings to make interest payments.

Some senior notes are convertible into shares of the issuer's common stock. The investor can choose to hold the senior note until maturity or convert the note into a specific number of common stock shares. Assume, for example, that a $1,000 senior note has a conversion option allowing the investor to convert into 20 shares of common stock. If the market price of the common stock increases to $60 per share, the investor owns shares worth $1,200 if he chooses to convert. Conversion gives the investor the opportunity to own equity in the company instead of owning a debt instrument.