Subordinated Debt Definition

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.

KEY TAKEAWAYS

 Subordinated debt is debt that is repaid after senior debtors are repaid
in full.
 It is riskier as compared to unsubordinated debt and is listed as a long-
term liability after unsubordinated debt on the balance sheet.
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. 1  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. 2  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.3

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.