The order of priority establishes a sequence of preference in debt collection that is determined based on its characteristics.
When companies are financed to undertake investment projects, they sometimes issue different types of instruments based on their current needs. These instruments are classified according to their credit quality. Depending on this, these instruments will be placed on one scale or another in the order of priority. In this way, the order of priority serves to establish the order in which investors could collect the money loaned to the company, in case it defaults or goes bankrupt.
Collection priority order
The order of priority from lowest to highest risk is presented below.
- Senior Secured Debt: It is the debt with the highest credit quality. They are known as cédulas hipotecarias (covered bonds in English). This debt is backed by a portfolio of mortgage loans from the issuer. This provides the Senior Secured Debt with a guarantee linked to a real asset. This endows it with a higher credit quality and a preference in the collection in case of default. This type of instrument can only be issued by credit institutions.
- Senior Debt: These are ordinary bonds or obligations issued by the company. Depending on the needs of the company and the market environment, the issues may differ in the type of coupon, maturities, indexation to some market variable or protection against inflation for example.
- Subordinated debt: This type of debt has a notably lower quality than the previous ones. This is because the collection of interest is linked to obtaining a certain level of benefits. In addition, in the event of default, this debt is subordinated to the collection of the higher tranches, that is, investors in subordinated debt would collect the money subsequently loaned from investors in debt of higher tranches (senior secured and senior). This is a great risk, since after paying off the debt of the upper tranches, there could be the possibility that there is no cash left or that this is not enough to meet the payment of the subordinates. Within this type of debt are the well-known preferred shares.
- Hybrid debt: An example might be convertible bonds or coconuts. In the event of bankruptcy or liquidation of the issuer, hybrid holders are only above shareholders in terms of collection priority. They are usually very long-term or perpetual instruments issued, with the issuer having the ability to cancel on certain dates (a call option is incorporated, that is, a right to redeem).
- Shares: When an investor buys shares, he becomes a partner in the company. Unlike debt holders (creditors), they do not enjoy any protection in the event of bankruptcy of the entity. For this reason, they are in the lower rung of the order of priority. In case of bankruptcy of the entity they would lose their money.
The same company can issue different types of debt depending on the instrument that is issued, said instrument will have a specific rating and this will have a direct impact on the risk that an investor assumes when buying said debt.