Subordinated Debt: Definition, Types & Example

KEY TAKEAWAYS

• Subordinated debt is also known as a subordinated debenture and it gets repaid only after senior debtors get paid in full.
• On the balance sheet of a company, subordinated debt is listed after unsubordinated debt and it’s classified as a long-term liability.

What Is Subordinated Debt? 

Different types of debt are ranked from highest to lowest. Subordinated debt is an unsecured debt, such as a bond or a loan, that ranks below other senior debts. These debts get ranked when it comes to the claim they have on different assets or earnings. 

Also known as subordinated debentures, subordinated debt falls into the junior securities category. So if a borrower ends up defaulting on their loan, any creditors that own the subordinated debt will be paid after senior bondholders are paid in full.

How Is Subordinated Debt Used?

Essentially, subordinated debt is a type of unsecured borrowing. So if the bank that issued the subordinated debt ended up going through liquidation, any subordinated debt would only get paid once other debt obligations are fulfilled. 

This includes deposit obligations and all of these must get paid in full before there is any payment to stockholders. The issuance of debt works slightly differently compared to traditional avenues, such as credit card debt.

Most borrowers of subordinated debt instruments are larger corporations or different types of business entities. It’s a riskier venture compared to unsubordinated debt, which is any type of loan that gets paid only after corporate debts are repaid. 

Types of Subordinated Debt

Within subordinated debt, there can be different types of loans that are going to have various levels of priority. Some of the most common types of subordinated debt include:

• Mezzanine debt, both with and without warrants 
• High yield bonds 
• Payment in kind (PIK) notes
• Vendor notes

As well, the above types of subordinated debt are listed from the highest to the lowest priority when it comes to repayment. Another way to think about it is with a subordination scale. In this case, vendor notes would have the highest subordination and high yield bonds would have the lowest. 

It’s also important to recognize that even with the different levels of subordination, there are also varying levels of expected return. So when an investor looks into potential subordinated debt, they’re going to have to weigh the risks to determine what the best reward tradeoff would be. 

For example, if there ends up being some type of financial stress, a high yield bond investor would end up with the highest priority to collect the debt. But on the flip side, they would receive the lowest return out of any of the subordinated debt creditors when it comes to payment pursuant to the terms. 

The treatment of debt would work the same way for vendor note creditors. They would have the lowest priority when it comes to collecting the debt, however, they would receive the highest expected return. 

It’s always important for management to explore other sources of capital beyond the top of the capital stack. This is since increased subordination will lead to an increase in equity dilution to help avoid the risk of default. 

The Risk Level of Subordinated Debt 

Subordinated debt can be much riskier compared to unsubordinated debt or other types of debt, so it’s always important to keep a few things in mind. This includes being aware of any other debt obligations, the company’s solvency, and the total assets when an issued bond is reviewed. 

However, even though it is riskier for lenders, it gets paid out before any payout to equity holders. As well, bondholders of subordinated debt benefit by being able to realize a higher rate of interest. This ultimately helps compensate for any of the potential risks of default. 

Subordinated Debt and Senior Debt

The biggest difference between subordinated and senior debt is that senior debt takes priority when it comes to claims being paid. This can happen if a company ends up facing liquidation or bankruptcy with outstanding debt obligations. 

Senior debt comes with the lowest risk and highest priority for repayment, meaning it usually carries lower interest rates. Subordinated debt carries a higher risk potential and when it comes to paybacks it has a lower priority. Senior debt is the highest priority debt. 

Basically, subordinated debt is any debt that ends up falling behind the priority of the senior debt portion. With that said, it’s worth mentioning that subordinated debt does not have priority over preferred and common equity. 

Perks of Subordinated Debt

While traditional forms of debt can bring their own set of advantages, subordinated debt can be complimentary. Plus, it brings a range of other benefits. These include:

• Maintaining capital on the balance sheet
• Enhancing the return on equity 
• Avoiding the possibility of dilution
• There are limited covenants or restrictions included in loan notes
• Helps facilitate business growth 
• Includes a range of potential tax benefits 

It’s worth noting as well that subordinated debt allows for broader access to investor classes. Previously, these classes may not have been accessible to most mid-sized insurers. 

Subordinated Debt Example

Let’s say that a company decides to file for bankruptcy. Any outstanding loans must get prioritized to be paid using liquidated assets. 

The company has senior debt of $900,000 and subordinated debt of $400,000. Once it files for bankruptcy, any and all assets must get liquidated to help repay the debt. The senior debt would then get paid off first.

Any leftover cash would go towards paying off the subordinated debt. However, if there is a lack of funds to cover the total amount of subordinated debt, only part would get repaid. 

Summary 

Subordinated debt is any type of debt that doesn’t get paid until all other senior debt ahead of it is paid in full. Debt holders and debt investors are going to receive a payout depending on the debt agreement. This can help get ahead of a subordinated debt issue, especially if it relates to company debt. 

In the case of a bankrupt company or if the company defaults on its debt obligations, subordinated debt would get paid out after the other payment priority levels. This aligns with certain regulatory requirements when it comes to bond types and disclosure requirements. Check with your bank or financial institution to find out what subordinated debt documents you might need. They will also look into the evaluation of default risk, the maximum maturity requirement, and any additional requirements.