Why being on top matters

The Sterling Report

Toni-Ann Neita-Elliot

Sunday, February 10, 2019

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The line of succession to the throne is the order in which members of the royal family would come to the throne if the reigning king or queen died. When someone who is first in line to the throne has a child, that child comes after them and their older children, but before anyone else in the line of succession.

Similarly, investors should know where their investment ranks in the hierarchy of a company's capital structure, as this ranking will determine the order of repayment in the event of a sale or bankruptcy of the issuer. I am sure you would want to be at the top of the ranking if this happens!

Within a typical business there are various financing securities used to fund existing operations and growth. Most companies will use a combination of both debt and equity. The debt may come in different forms including senior secured loans and unsecured bonds, while equity typically comes as preference or ordinary shares. The exact combination of these instruments forms the company's “capital structure”.

SENIORITY

Each security, whether debt or equity, that a company issues has a specific seniority or ranking. Seniority refers to the order of repayment in the event of a sale or the bankruptcy of the issuer. Any security labelled “senior” in such a structure is one that takes primacy over any other company's sources of capital.

Holders of the most-senior securities will always be first to receive payout from a company's holdings in the event of default. Then would come those security-holders whose securities are deemed second-highest in seniority, and so forth until the assets used to pay off such debts run out.

When comparing debt to equity, debt always has seniority in the payout order. In fact, equity is ranked the lowest amongst the various claims on a company's assets. In more complicated terms, equity is “subordinated” to other forms of claims on a company. This means in the event of a company's liquidation; equity holders get paid last — with holders of preference shares receiving their payout before ordinary shareholders do.

Due to the priority given to senior bonds versus junior or “subordinated” bonds, it should be expected that junior bonds offer a higher yield versus senior bonds. As such, an investor looking at a particular company's bonds (particularly one with both senior and junior debt tranches) should take seniority into consideration when assessing the yield of a particular bond issue.

SECURITY

Debt may be senior in the hierarchy but without any security (“senior unsecured”). When comparing unsecured debt to secured debt, secured debt has seniority.

If a bond is classified as a secured bond, it means the issuer is backing it with collateral- usually some specific company assets such as industrial equipment, a warehouse or a factory. In the event of a bankruptcy, such assets are separated from the rest of the company's assets and used to pay this specific group of secured creditors. Including collateral in the bond arrangement usually provides a higher sense of security to the bond investor, which often allows the issuer to offer such bonds at lower yields versus unsecured borrowings.

But it is important to note that collateral can lose value in the case of a company bankruptcy and so investors should assess the quality of the collateral provided. Investors should also note that the same assets can be used as collateral for various tranches of secured bonds, and that there may also be seniority and subordination of claims on these collateralised assets in the event of a default.

Given the primacy of certain claims over others it is not surprising that the lowest-ranked claims (equity) are rewarded with the highest potential returns (equity investors share the profits of a company), while the most senior debt for a company will usually have a lower yield compared to a subordinated or junior issue.

This was a very simplified version of how to determine where your investment ranks. As always, before making any investment decision, whether it is in equity or bonds, it is important to consider whether you are adequately compensated for the risks you are taking. Understanding where your investment sits in the capital structure will help you in making that assessment and increase your odds of coming out on top in the event of a default.

Toni-Ann Neita-Elliott is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm


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