Junior Debt

Junior Debt — What It Is and How It Works

Junior debt, also called subordinated debt, refers to loans or bonds that rank below senior debt in the priority of repayment. If a borrower defaults or is liquidated, senior creditors are paid first; junior creditors are paid only after senior claims are satisfied. Because of this lower priority, junior debt typically carries higher interest rates to compensate investors for the greater risk.

Key points

• Junior debt = subordinated debt; repaid after senior debt in default.
• Often unsecured or less-secured than senior debt, so recovery in default is lower.
• Carries higher interest rates and yields than senior debt.
• Common in both corporate finance and real estate financing (e.g., second mortgages, mezzanine loans).

How repayment priority works

Capital structure generally follows this order in repayment priority:
1. Senior debt (first lien lenders)
2. Junior/subordinated debt (second liens, mezzanine)
3. Preferred equity
4. Common equity

Seniority is set by loan documentation and lien positions. Senior debt may be secured by collateral; junior debt is frequently unsecured or secured by subordinate liens that are enforceable only after senior claims.

Why junior debt pays higher yields

Because junior creditors face a higher risk of loss if the borrower fails, investors demand higher coupons or interest rates. The higher return compensates for:
* Lower or no collateral coverage
* Lower recovery rates in bankruptcy or foreclosure
* Potential for limited influence over borrower decisions compared with senior lenders

Common forms in real estate

In real estate finance, junior debt appears in several forms:
* Second mortgages (a junior lien behind the first mortgage)
* Mezzanine loans (often structured as debt secured by equity interests rather than the property itself)
* B-notes (subordinate portions split off from an original loan after the senior “A-note”)
These instruments let borrowers increase leverage or fill financing gaps without replacing the senior mortgage.

Structured products and tranches

In securitizations and structured financings, debt can be split into tranches with descending repayment priority:
* Senior tranches receive payments first and have lower yields.
* Junior or equity tranches absorb losses first and are repaid last (examples include “z‑tranches”).
Tranche structure determines cash-flow allocation and default exposure for each investor class.

Investor considerations

Before investing in junior debt, evaluate:
* Position in capital stack and lien priority
* Whether debt is secured and the nature of collateral
* Loan-to-value (LTV) and expected recovery in default
* Interest rate, fees, and other compensation for subordinated risk
* Covenants, default remedies, and intercreditor agreements with senior lenders
* Liquidity and secondary marketability

What happens in default

In a default or foreclosure, senior lenders enforce their claims first. Junior creditors:
* May receive only partial repayment or none at all if senior claims exhaust collateral value
* Can negotiate workouts, replenishment, or debt-for-equity swaps
* In some cases may foreclose on their subordinate lien, but their recovery remains behind the senior lien

Bottom line

Junior debt is a higher-risk, higher-yield form of financing that sits below senior obligations in repayment priority. It is commonly used to increase leverage or bridge financing needs, especially in real estate (second mortgages, mezzanine loans). Investors should carefully assess lien position, collateral, contract terms, and potential recovery scenarios before participating in subordinated debt.