Question

1. Define and explain the following terms(in own words):

Secured versus unsecured debt:

Senior versus subordinated debt:

2. Compare 30-year bond to a 5-year bond all else equal. Which one is more sensitive to interest rate changes. Why? Please explain.

Answer 1

1) Secured debt versus unsecured debt :

A secured debt means that the debt is charged against an asset of the company. For instance, a long-term debt could be secured against long-term assets of the company, such as : machinery, land, building etc. While, a short-term debt could be secured against working capital assets like inventories, accounts receivables or a combination of both. In an event of default or liquidation, the lenders will be paid through selling these assets.

For example, Bank ABC has lent $1 million to a company; and the loan is secured against machinery worth $800,000. If the company has an outstanding amount of $900,000 (including interest) after a couple of years and defaults on the loan, the bank will sell the machinery to recover its loan. Generally, documents related to the assets is in possession of the bank.

Unsecured debt, as the name suggests, is not secured against any asset. In the event of default or liquidation, unsecured debt rank after secured debt. The lenders are paid from the residual amount left after secured loan is repaid.

Unsecured debt is riskier than secured debt and hence the interest charged by unsecured lenders would be higher than that of secured debt. Furthermore, credit criterias are more stringent for unsecured debt, which means that generally corporations with good track-record and credit metrics have better chances of  raising unsecured debt

2) Senior debt versus subordinated debt

Senior debt ranks higher in priority of payment to subordinated debt. When a company files bankruptcy or enters into liquidation, the senior debt-holders are paid first, and the residual amount (if any) is then paid to subordinated debt holders.

Let's say ABC has entered into liquidation. It has a land worth $1.5 million. Senior debt of $ 1million and subordinated debt of $ 1million.

After selling the land, the proceeds would be used to pay the senior debt first . While, the remaining $500,000 would be paid to subordinated debt holders. Which means that they bear a loss of $ 500,000.

A subordinated debt could also be secured in nature. However, based on negotiation, their rank would be lower than the senior debt having charge on the same asset (generally, called as second charge).

For example, a land could be given as a first charge against Loan 1. After a few years, the company takes another loan (Loan 2) against the same land, but for a second charge.

In the event of liquidation, the proceeds would be first paid to lenders of loan 1 and then the lenders of loan 2 (since they have a second charge, their priority would be second to loan 1)

A senior debt will ideally be having a lower interest rate to a subordinated debt.

3) Sensitivity to interest rate change : 30 year bond v/s 5 year bond

The price of the bond is inversely related to the interest rates. When interest rate rises, the price of the bond falls and vice-versa.

Sensitivity of the bond is directly linked to duration of the bond. This is because duration is a function of tenor of the bond, the time after which coupon payments and redemption amount of the bonds would be received.

The likelihood of interest rates rising over a 30 year period is signifcantly higher as compared to 5 year period. Uncertainties involved which affect the interest rate is certainly more in a 30 year horizon. Furthermore, the investor would be receiving back the principal investment and coupon payments in a 30 year bond much later as compared to a 5 year bond.

Therefore, a 30 year bond would be more sensitive to interest rate changes to a 5 year bond.