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A senior bond is a type of debt security that has a superior claim on the assets and income of the entity that issues the bond. This means that in the event that the issuer encounters some type of financial problem, investors who hold a senior bond will be paid before investors holding a bond issue with less claim in the resources of the issuer. Bonds of this type carry less risk, which may be an important factor for some investors.
While bonds are generally considered to be safe investments, securing a senior bond simply adds to the security of the investment. It is important to note that bond issues are structured with varying levels of claim on the assets of the issuer in the event of some type of financial problem. Bonds that have secondary claim on the issuer’s assets are classed as junior bonds. Those with the strongest claim on those same assets are referred to as being senior bond issues.
Along with having a greater claim on the asset of the issuer, a senior bond also differs from a junior bond in terms of the interest rate that applies to the investment. Since a senior debt security carries less risk than a junior debt security, the rate of interest earned with the senior security is less than the rate offered for a junior or subordinated bond. As with most types of investments, the more risk that the investor is willing to assume, the greater the potential return offered by the bond issuer.
There are three common financial problems that may result in an inability to honor bond issues. The issuing entity may encounter temporary cash flow issues, making it difficult to make interest payments on time. Financial setbacks may be so severe that the issuer defaults on the bonds altogether. If the problems are severe enough, the entity may be driven into bankruptcy, where a court decides when and if the debt obligations are repaid.
In situations where at least partial payments on the bond issues are ordered by the court, an investor holding a senior bond will receive his or her portion ahead of the subordinated bond holder. Even in this situation, there is no guarantee that the senior bond holder will receive full compensation, especially in a bankruptcy situation. The only real guarantee is that if any compensation is made to bond holders, those with senior debt securities will be paid ahead of the rest.
Bond issues are generally very safe investments, but that does not preclude the need for an investor to investigate the issuing entity closely before purchasing a senior bond issue. Making sure the entity is stable and is likely to remain so throughout the life of the bond is very important. Taking this course of action greatly increases the chances of earning a full return on the bond, rather than possibly losing money on the investment.
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