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What is unsecured debt?

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Unsecured debt is any type of debt that is not secured by any specified asset or group of assets in the event of the borrower’s default on its financing and that does not have any priority claim in the event of borrower dissolution and sale of the company’s assets.  Unsecured lending is pure cash-flow based lending since its primary source of repayment is the cash flow from the borrower’s operations.

Recovery Rate of US Unsecured Debt 1987-2007
Financial Instrument Mean %
Unsecured revolving credit 62.8%
Unsecured term loans 43.5%
Senior unsecured bonds 43.7%
Senior subordinated bonds 28.7%
Subordinated bonds 23.8%
Junior subordinated bonds 11.6%
Source: S&P’S

Unsecured lending inevitably involves a much higher degree of risk than secured lending since loan repayment is completely dependent on the borrower’s intention and ability to repay.  It may be either unsubordinated or subordinated.

Secured debt generally has full priority over any unsecured claims in bankruptcy but only up to the value of the collateral.  Any portion of the secured claim that is not satisfied by the assets in which the security interest was taken ranks as any other unsecured, unsubordinated debt, having general creditor status.

Although security increases the expected recovery value of secured debt upon the insolvency of the borrower, it also decreases the expected recovery value of the unsecured debt by reducing the assets available to satisfy unsecured creditors.  In theory, the reduction in interest rate paid on secured debt should be exactly offset by the increased interest rate paid on unsecured debt.

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