Debt, Covenants, and Credit Ratings

Why this matters

Shareholders tend to look at debt as one number. Lenders don't. They negotiate who's paid first, when, and what the company is and isn't allowed to do in the meantime. Those terms decide what happens when business turns down, and by then it's too late to read them. A shareholder is last in line, so the people ahead of them, and the rights those people hold, are worth knowing about.

Who gets paid first

If a company can't pay its debts, its lenders are repaid in an order set by the terms of each loan or bond. Priority depends on whether a bond is, for example, a secured bond, a senior unsecured bond, or a junior, also called subordinated, bond. With a secured bond, the company pledges specific assets as collateral, and if it defaults, those lenders can claim them. In a bankruptcy, all of the lenders rank ahead of shareholders.¹

Claim, in order	Amount owed	Receives	Share recovered
Secured bank loan	300	300	100%
Senior unsecured bonds	400	300	75%
Subordinated bonds	200	0	0%
Shareholders		0	0%
Total value of the business		600

The business is worth $600 million and owes $900 million. The secured lender is paid in full. The senior bondholders share what's left and recover 75%. The subordinated bondholders and the shareholders get nothing. Real cases are messier and negotiated, as Bankruptcy and Restructuring describes, but the order is the starting point for every negotiation.

This is why the same company can borrow at very different rates on different pieces of debt, and why a subordinated bond behaves more like a share when things go wrong.

When the debt falls due

Most company debt isn't paid off from profits. It's replaced with new debt when it matures. That works while lenders are willing, which makes the schedule of maturities as important as the total. A company with $900 million of debt spread evenly over ten years is in a very different position from one that owes $600 million of it next year.

The interest rate matters too. Some debt pays a fixed rate, and some pays a floating rate that's reset periodically against a benchmark.¹ Floating-rate debt costs more as soon as interest rates rise. Fixed-rate debt is protected until it has to be refinanced.

The rest of this lesson is for members

Still to come in this lesson: Covenants, Credit ratings, Where to look, and what to watch for, the key takeaways, and 2 quiz questions with explanations.

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