Junior Tranche: Definition, Uses, Calculation & Example

KEY TAKEAWAYS

• Bonds or other obligations with a lesser priority than senior debt are referred to as junior tranches.
• Junior tranches, often referred to as subordinated debt, will only be reimbursed in the event of default or bankruptcy. This is following the complete repayment of more senior loans.
• Junior tranche is not normally backed by any kind of collateral, in contrast to senior debt.
• These characteristics make junior tranches have a higher risk and subject to higher interest rates than senior debt.

What Is Junior Tranche?

A junior tranche is an unsecured debt that, in the case of default, has a lower priority for repayment than other debts. It is also known as subordinated debt or junior debt. When a business declares bankruptcy or liquidation, payments are made to the creditors. This is according to priority, with senior debt receiving paid first.

In structured finance, the French term “tranche” is employed. The word “tranche” translates to “slice” or “portion.” Therefore, if we combine junior and tranche, we would understand what the term “lowest tranche of security” means. Therefore, when we refer to the junior tranche, we mean the lowest form of debt.

What Is a Junior Tranche Debt?

Bonds or other types of debt with a lesser priority for repayment than other, more senior debt claims are referred to as junior debt. Due to this, junior debt from the same issuer typically carries higher interest rates. This is when compared to more senior debt because it tends to be riskier for investors.

Junior debt may more broadly apply to any second layer of debt that is repaid after senior debt. Since all debt with a higher priority will be paid first, junior debt has a somewhat lower likelihood of being repaid in default.

How Are Junior Tranches Used?

In general, there are fewer regulations on the corporate loan market than on the equity market. As a result, firms have more freedom when borrowing money. A company may collaborate with a bank to get a loan. 

Additionally, they might collaborate with an underwriter who heads a lending syndicate. This may include numerous investors in a loan arrangement. Additionally, a business may issue bonds with various repayment terms.

Why Are Junior Tranches Used?

In the issuance of collateralized mortgage obligations, collateralized debt obligations (CDO), or asset-backed securities, junior tranches are utilized as a component of debt securitization. Junior debt may be preferred over selling new shares to the public. This could dilute the company’s ownership, despite the fact that firms prefer not to do so because of the junior debt’s higher interest rates.

The issuance of junior debt can be used to fund acquisitions or recapitalization, leveraged buyouts, or growth capital. Subordinated debt, and preferred stock may be combined. This is with the aim of producing a hybrid security that provides a dividend to the holder and is supported as an interest charge by the issuer.

How to Record a Junior Tranche Debt?

Assets are listed first on a balance sheet, followed by liabilities, and then shareholder equity. Junior debt is reported in the liabilities section because it is borrowed money. Long-term obligations are recorded after current liabilities in the liabilities section. The long-term obligations section records senior debt first, followed by junior debt.

The item that would be paid first in the case of a liquidation comes first when recording long-term liabilities. The cash profits from the sale of subordinated debt bonds by an organization are documented in the cash account. And if the borrowed money was used to purchase property or equipment, it is recorded as property, plant, and equipment in the assets section.

To put it in a step-by-step way, here is how you record a junior tranche debt on a balance sheet: 

• Current liabilities are listed first in the balance sheet’s liability section.
• The long-term obligations are recorded following the current liabilities.
• Senior debts are listed first under long-term obligations. This is because they would be paid off first if a company experienced bankruptcy. 
• Junior debts are reported following the senior debts.

How to Repay a Junior Tranche

A firm may divide the debt it issues into subordinated and unsubordinated debt. Holders of unsubordinated debt are positioned above holders of subordinated debt. This is in the general hierarchy of repayment schemes. The corporation has the option to file for bankruptcy in a bankruptcy court if it is unable to pay its debt commitments. If the court grants the request, a liquidator will be appointed. This is with the aim of selling the company’s assets and paying creditors according to their priority.

The senior or unsubordinated debt holders will be compensated first, followed by all other creditors. The subordinated, or junior, debt holders are paid first if there is spare money after the unsubordinated creditors have been paid. The complete amount of the company’s debts could be paid to the creditors or just a partial payment.

Example of a Junior Tranche Debt

Let’s imagine Company X declares bankruptcy. Now that Company X has declared bankruptcy, the business will be liquidated and its creditors will be paid in priority order.

There are currently two debt holders: senior debt holders and junior debt holders, often known as junior tranche holders.

Senior debt holders will be compensated first following the liquidation of Company M. The junior tranche will be paid if there is anything left over after paying the senior debt holders.

The junior tranche receives a higher interest rate as compensation for the risk because the risk is substantially larger than that of the senior debt holders.

Summary

Bonds or other types of debt with a lesser priority for repayment than other, more senior debt claims in the event of default are referred to as junior tranche. It can also be referred to as junior debt. 

Due to this, junior debt from the same issuer typically carries higher interest rates than more senior debt because it tends to be riskier for investors.
The issuance of junior debt can be used to fund acquisitions, recapitalization, leveraged buyouts, or growth capital. To produce a hybrid security that provides a dividend to the holder and is supported as an interest charge by the issuer, subordinated debt, and preferred stock may be combined.