Definition

• Junior debt represents a corporation's unsecured liabilities. Junior debt is also referred to as subordinated debt, due to its position in a firm's debt hierarchy. For example, an insurance company borrows $1 million from an investment bank. The loan is unsecured and the insurer agrees to reimburse in three years. If the borrower files for bankruptcy or faces significant financial difficulties, the lender may incur up to $1 million in losses if it is unable to recover any amount in court.
  
  

Types

• Types of junior debt products may vary, depending on the transaction, the loan amount and the legal status of business partners. A corporation may raise cash by selling unsecured bonds on a securities exchange, such as the New York Stock Exchange (NYSE). Or it may sign a line of credit agreement with a bank or an insurance company. A firm also can receive an overdraft agreement from a lender to cover temporary cash needs.
  
  

Significance

• A subordinated debt transaction is critical to a borrower and a lender. A profitable company may need to borrow to meet short-term business demands because customers typically do not pay for goods on delivery. A firm benefits when it borrows unsecured funds from a bank because it does not post any collateral, that is, it does not provide a financial guarantee to the lender. A bank that approves an unsecured loan may suffer financial losses if the borrower defaults.
  
  

Credit Risk

• Credit risk is the risk of loss that arises from a business partner's (also called counterparty) inability to reimburse a junior loan when it becomes due, or meet other financial commitments on time. A counterparty may default on junior debt because of bankruptcy or temporary financial difficulties. If a bank, for instance, approves an unsecured $500,000 loan for a borrower, it does not receive any financial guarantee, and may incur credit losses if the borrower is out of business.
  
  

Debt Accounting

• Financial accounting and reporting regulations, such as international financial reporting standards (IFRS) and generally accepted accounting principles (GAAP), require corporations to record junior debt at current value. For instance, an accountant—at the firm receiving the $500,000 unsecured loan—records the transaction by debiting the cash account for $500,000 and crediting the loan payable account for the same amount.