The bond contract gives bondholders the right to take legal action if the issuer fails to make the promised payments or fails to satisfy other terms specified in the contract. If the bond issuer fails to make the promised payments, which is referred to as default, the debtholders typically have legal recourse to recover the promised payments. In the event that the company is liquidated, assets are distributed following a priority of claims, or seniority ranking. This priority of claims can affect the amount that an investor receives upon liquidation.

The par value (principal) of a bond plus missed interest payments represents the maximum amount a bondholder is entitled to receive upon liquidation of a company, assuming there are sufficient assets to cover the claim. Because debt represents a contractual liability of the company, debtholders have a higher claim on a company’s assets than equity holders. But not all debtholders have the same priority of claim: borrowers often issue debt securities that differ with respect to seniority ranking. In general, bonds may be issued in the form of secured or unsecured debt securities.

Secured. When a borrower issues secured debt securities, it pledges certain specific assets as collateral to the bondholders. Collateral is generally a tangible asset, such as property, plant, or equipment, that the borrower pledges to the bondholders to secure the loan. In the event of default, the bondholders are legally entitled to take possession of the pledged assets. In essence, the collateral reduces the risk that bondholders will lose money in the event of default because the pledged assets can be sold to recover some or all of the bondholders’ claim (missed coupon payments and par value).

Unsecured. Unsecured debt securities are not backed by collateral. Consequently, bondholders will typically demand a higher coupon rate on unsecured debt securities than on secured debt securities. A bond contract may also specify that an unsecured bond has a lower priority in the event of default than other unsecured bonds. A lower priority unsecured bond is called subordinated debt. Subordinated debtholders receive payment only after higher-priority debt claims are paid in full. Subordinated debt may also be ranked according to priority, from senior to junior.

Exhibit 1 shows an example of the seniority ranking of debt securities.