What Is Subordinated Debt?

Subordinated debt (also known as a subordinated debenture) is an unsecured loan or bond that ranks below other, more senior loans or securities with respect to claims on assets or earnings. Subordinated debentures are thus also known as junior securities. In the case of borrower default, creditors who own subordinated debt will not be paid out until after senior bondholders are paid in full.

Understanding Subordinated Debt

Subordinated debt is riskier than unsubordinated debt. Subordinated debt is any type of loan that's paid after all other corporate debts and loans are repaid, in the case of borrower default. Borrowers of subordinated debt are usually larger corporations or other business entities. Subordinated debt is the exact opposite of unsubordinated debt in that senior debt is prioritized higher in bankruptcy or default situations.

Subordinated Debt: Repayment Mechanics

When a corporation takes out debt, it normally issues two or more bond types that are either unsubordinated debt or subordinated debt. If the company defaults and files for bankruptcy, a bankruptcy court will prioritize loan repayments and require that a company repay its outstanding loans with its assets. The debt that is considered lesser in ;priority is the subordinated debt. The higher priority debt is considered unsubordinated debt.

The bankrupt company's liquidated assets will first be used to pay the unsubordinated debt. Any cash in excess of the unsubordinated debt will then be allocated to the subordinated debt. Holders of subordinated debt will be fully repaid if there is enough cash on hand for repayment. It's also possible that subordinated debt holders will receive either a partial payment or no payment at all.

Since subordinated debt is risky, it's important for potential lenders to be mindful of a company's solvency, other debt obligations, and total assets when reviewing an issued bond. Although subordinated debt is riskier for lenders, it's still paid out prior to any equity holders. Bondholders of subordinated debt are also able to realize a higher rate of interest to compensate for the potential risk of default.

While subordinated debt is issued by a variety of organizations, its use in the banking industry has received special attention. Such debt is attractive for banks because interest payments are tax-deductible. A 1999 study by the Federal Reserve recommended that banks issue subordinated debt to self-discipline their risk levels. The study's authors argued that issuance of debt by banks would require profiling of risk levels which, in turn, would provide a window into a bank's finances and operations during a time of significant change after a repeal of the Glass-Steagall Act. In some instances, subordinated debt is being used by mutual savings banks to buffer up their balance to meet regulatory requirements for Tier 2 capital.

Subordinated Debt: Reporting for Corporations

Subordinated debt, like all other debt obligations, is considered a liability on a company's balance sheet. Current liabilities are listed first on the balance sheet. Senior debt, or unsubordinated debt, is then listed as a long-term liability. Finally, subordinated debt is listed on the balance sheet as a long-term liability in order of payment priority, beneath any unsubordinated debt. When a company issues subordinated debt and receives cash from a lender, its cash account, or its property, plant, and equipment (PPE) account, increases, and a liability is recorded for the same amount.

Subordinated Debt vs. Senior Debt: An Overview

The difference between subordinated debt and senior debt is the priority in which the debt claims are paid by a firm in bankruptcy or liquidation. If a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation, the senior debt is paid back before the subordinated debt. Once the senior debt is completely paid back, the company then repays the subordinated debt. Senior debt has the highest priority, and therefore the lowest risk. Thus, this type of debt typically carries or offers lower interest rates. Meanwhile, subordinated debt carries higher interest rates given its lower priority during payback. Senior debt is generally funded by banks. The banks take the lower risk senior status in the repayment order because they can generally afford to accept a lower rate given their low-cost source of funding from deposit and savings accounts. In addition, regulators advocate for banks to maintain a lower risk loan portfolio.

Subordinated debt is any debt that falls under, or behind, senior debt. However, subordinated debt does have priority over preferred and common equity. Examples of subordinated debt include mezzanine debt, which is debt that also includes an investment. Additionally, asset-backed securities generally have a subordinated feature, where some tranches are considered subordinate to senior tranches. Asset-backed securities are financial securities collateralized by a pool of assets including loans, leases, credit card debt, royalties, or receivables. Tranches are portions of debt or securities that have been designed to divide risk or group characteristics so that they can be marketable to different investors.