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Subordinated Debt: Definition – Overview – Explanation

What Is Subordinated Debt?

Subordinated DebtSubordinated debt is an unsecured obligation that ranks lower in terms of claims on assets or profits than more senior loans or obligations. This type of debt is also known as a subordinated debenture.  It is an unsecured loan or bond that ranks lower in terms of claims on assets or profits than other, more senior loans or securities. As a result, subordinated debentures are often referred to as junior securities. In the event of borrower default, subordinated debt creditors will not be reimbursed until senior bondholders have been paid in full.

Even within the category of subordinated debt, however, there are many sorts of loans with varying degrees of priority. High yield bonds, mezzanine with and without warrants, Payment in Kind (PIK) notes, and vendor notes are examples of subordinated debt, with the highest priority coming first. There are different degrees of expected return for different levels of subordination. As a result, investors base their judgments on the risk-reward tradeoff. High-yield bond investors, for example, have the greatest priority to collect debt in the event of financial trouble.  As a result, they will get the lowest return of all subordinated debt creditors. Vendor note creditors, on the other hand, have the lowest priority for debt collection but the greatest projected return of any lender.

Subordinated Debt Repayment

When a firm incurs debt, it often issues two or more bond types: unsubordinated debt and subordinated debt. If the firm fails and declares bankruptcy, the bankruptcy court will prioritize debt repayments and order the corporation to repay its outstanding loans with its assets. The subordinated debt is the debt that is regarded as having a lower priority. Unsubordinated debt is debt with a greater priority than the debt with the lowest priority.

Simply put, subordinated debt has a higher risk than unsubordinated debt. In the event of borrower default, subordinated debt is any sort of loan that is paid after all other company obligations and loans have been repaid. Borrowers are often larger businesses or sizeable commercial organizations. Senior debt is prioritized higher in the event of bankruptcy or default.

The liquidated assets of the insolvent firm will be utilized first to pay down the unsubordinated debt. Any additional funds remaining will be assigned to the remaining debt. Holders of senior debt will be completely repaid if there is sufficient cash on hand. It is also possible that holders of subordinated debt would either get a partial payment or no payment at all. Subordinated debt is hazardous.  Potential lenders should consider a company’s stability, other debt commitments, and overall assets when analyzing a subordinated bond issue. Although junior debt is riskier for lenders, it is nevertheless paid out before equity investors. Bondholders of junior debt can also benefit from a higher interest rate to compensate for the risk of default.

Subordinated Debt Tax Implications

Subordinated debt is issued by a wide range of entities.  However, its application in the banking industry has gained particular attention. Banks like this type of debt because the interest payments are tax-deductible.  According to a 1999 Federal Reserve research, banks should issue subordinated debt to self-discipline their risk levels. The study’s authors suggested that bank debt issuance would necessitate risk-level profiling.  In turn, this would give a window into a bank’s finances and operations during a period of substantial upheaval.  Particularly after the repeal of the Glass-Steagall Act. In certain cases, mutual savings banks employ subordinated debt to shore up their balances in order to fulfill Tier 2 capital requirements.

With such a complex and changing environment, one way to encourage safety and soundness is to enhance the ‘‘market discipline’’ imposed on banking organizations. In this study, we distinguish between direct and indirect market discipline. Direct market discipline is exerted through a risk-sensitive debt instrument when a banking organization’s expected cost of issuing that instrument increases substantially with an increase in the organization’s risk profile. For such discipline to occur, investors must gather and collect information about the banking organization’s risks and prospects and then incorporate that information into the decisions to buy and sell the organization’s debt. The anticipation of higher funding costs provides an incentive ex ante for the banking organization to refrain from augmenting its risk.  (Source: federalreserve.gov)

Subordinated Debt Reporting for Corporations

Subordinated debt, like all other debt obligations, is accounted for on a company’s balance sheet as a liability. On the balance sheet, current obligations are listed first. The senior debt, also known as unsubordinated debt, is then classified as a long-term liability. Subordinated debt is reported as a long-term obligation on the balance sheet, underneath any unsubordinated debt, in order of payment priority. When a company issues subordinated debt, an asset account increases by an equivalent amount.  For example, if it receives cash from a lender, its cash account increases reflecting the liability it assumes.

Junior Debt vs. Senior Debt

The distinction between subordinated and senior debt is the order in which debt claims are paid by a company in bankruptcy or liquidation. If a corporation is forced to file for bankruptcy or liquidation, the senior debt gets paid off first. Once the senior loan has been fully repaid, the corporation will repay the subordinated debt.

  • Senior debt is given the greatest priority and hence has the lowest risk. As a result, this sort of debt usually has or provides reduced interest rates. Meanwhile, because of its lower priority during repayment, subordinated debt bears a higher interest rate. Banks typically fund senior debt. Banks choose the lower risk senior position in the repayment sequence.  They can often afford to accept a lower rate given their low-cost financing source from deposit and savings accounts. Furthermore, authorities advise banks to keep a lower-risk lending portfolio.
  • Junior debt is any debt that has a lower priority and follows after senior debt. However junior debt takes precedence over preferred and common stock. Mezzanine debt, which is debt that also contains an investment, is an example of subordinated debt. Furthermore, asset-backed securities typically incorporate a subordinated characteristic.  For example, some tranches are regarded as subordinate to senior tranches. Asset-backed securities are financial instruments that are backed up by a pool of assets.  These include loans, leases, credit card debt, royalties, or receivables. Tranches are sections of debt or securities that are meant to partition risk or group features.  This allows them to be sold to various investors.

Why Would a Bank Accept Subordinated Debt?

Why would a person, bank, or financial institution accept a subordinated debt arrangement?

  • Preferential treatment for large customers – Usually, this structure is generally only available to large firms with an existing relationship.
  • Existing relationship – When a corporation needs additional money in the form of capital, it seeks companies or banks with which it has a good connection. Because of the nature of the commercial connection, the contacted firms are unable to say ‘no’ to a large, existing customer.
  • Relaxed requirements – Due to the preexisting relationship, the bank can offer a lower rate for its largest customers.  It is also willing to consider a subordinated arrangement for the debt payment.

Up Next: What Is a Stock Rights Offering and Issue?

Stock Rights OfferingA stock rights offering is an opportunity granted to existing shareholders to acquire more stock shares in proportion to their current holdings.  The new shares are known as subscription warrants and are considered a sort of option.  A stock warrant is issued directly by the company in question.  When an investor exercises a stock warrant, the shares that satisfy the obligation are obtained directly from the firm rather than through another investor. Rights offerings grant investors in a firm the right, but not the obligation, to acquire more shares in the company. The subscription price at which each share may be acquired in a rights offering is often reduced relative to the current market price. Rights are frequently transferrable, which allows the possessor to sell them on the open market.

In simple terms, a stock rights offering is a way for companies to raise money. Aside from posting earnings, businesses generate funds in two ways.  Either by borrowing or by selling ownership holdings in the firm. The former entails issuing bonds (IOUs), whereas the latter entails issuing shares. A stock rights offering addresses current shareholders and gives them the option to purchase more shares of stock.  The offering period is for a limited time, which can range from a few weeks to a few months. Companies might further entice investors to buy additional shares by offering them at a discount.

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