Subordinated Debt

Subordinated debt (or subordinated debentures) is debt that ranks below other obligations in priority of claim on a borrower’s assets and earnings. In a default or liquidation, subordinated creditors are paid only after senior (unsubordinated) creditors have been fully satisfied. Because of this lower claim priority, subordinated debt typically carries higher interest rates to compensate investors for greater risk. Subordinated debt still ranks above preferred and common equity.

Key takeaways

• Subordinated debt is junior to senior debt in repayment priority but senior to equity.
• It is generally unsecured and carries higher interest rates than senior debt.
• In bankruptcy, subordinated creditors may receive partial or no repayment if senior claims exhaust the estate.
• Common uses include corporate financing, mezzanine financing, and certain tranches of asset-backed securities; banks may use subordinated debt to support regulatory capital.

How subordinated debt differs from other debt

• Priority: Senior debt is repaid first; subordinated debt is repaid only afterward.
• Risk and return: Subordinated debt is riskier and therefore offers higher yields.
• Typical lenders: Senior debt often comes from banks or secured lenders; subordinated debt may be marketed to institutional investors seeking higher yield.
• Position relative to equity: Subordinated debt is paid before preferred and common shareholders.

Repayment and bankruptcy treatment

• When a borrower defaults, a bankruptcy process ranks claims and distributes available assets.
• Liquidation proceeds first satisfy secured and senior unsecured liabilities. Any remaining funds go to subordinated creditors.
• If proceeds are insufficient, subordinated creditors may be partially paid or receive nothing.

Corporate reporting

• Subordinated debt appears on the balance sheet as a long-term liability and is disclosed in order of payment priority beneath unsubordinated (senior) debt.
• Issuance increases cash (or PPE) and creates a corresponding liability for the principal amount received.

Common forms and structures

• Mezzanine debt: A hybrid between debt and equity, often with warrants or conversion features; typically subordinated.
• Asset-backed securities (ABS): Often structured in tranches; subordinate tranches absorb losses before senior tranches and therefore offer higher yields.
• Bank capital: Some subordinated instruments qualify as Tier 2 capital under regulatory frameworks, providing loss-absorbing capacity.

Use in banking and regulation

• Banks may issue subordinated debt as part of capital management; interest payments are generally tax-deductible.
• Regulators and researchers have noted subordinated debt can promote market discipline by revealing risk pricing and incentivizing prudent risk management.

Risks and benefits for investors

Benefits:
* Higher yield compared with senior debt.
* Priority over equity in the capital structure.

Risks:
* Greater loss severity in default or bankruptcy.
Potentially limited liquidity and fewer protective covenants.
Sensitivity to the issuer’s overall leverage and asset quality.

Investor considerations:
* Assess the issuer’s solvency, leverage, and asset coverage.
Review the subordination terms and any covenants.
Understand where the instrument sits relative to other tranches and creditors.
* Consider recovery scenarios and historical recovery rates for similar instruments.

Conclusion

Subordinated debt is a useful financing tool that balances higher investor yield against higher risk. It plays a distinct role in corporate capital structures and structured finance, and it can contribute to bank capital frameworks. Investors should carefully evaluate the issuer’s financial strength, the specific subordination terms, and potential recovery outcomes before investing.

Sources

• Internal Revenue Service, Publication 535: Business Expenses.
• Federal Reserve, Using Subordinated Debt as an Instrument of Market Discipline.
• Federal Deposit Insurance Corporation, Capital (Section 2.1).