Subordinated Debt – Meaning, Example, Risk, and More

Subordinated debt is a debt that ranks lower than most other types of debt and
securities in terms of claims on the borrower’s assets. In simple words, we can say
that if a borrower defaults, the lender of the subordinated debt will get the payment
only after the payment is made to all other debt holders. We can also call it a junior
debt, subordinated bond, or subordinated debenture. It is the opposite of
unsubordinated debt.

After a company or a person files for bankruptcy, it is up to the court to decide the
ranking of the debts. A debt that a court decides is not a priority will be
subordinated debt. The assets of the bankrupt company will first be used to repay
the unsubordinated debt. Then any funds left after paying the unsubordinated debt
will go towards paying the junior debt. Thus, it is possible that lenders of such debt
receive partial payment or no payment at all.

Table of Contents
1. Risk Level in Subordinated Debt
2. Example of Subordinated Debt
3. Types of Subordinated Debt
1. Bank Loan or Bond
2. Mezzanine Debt
3. Asset-backed Security
4. Common Stock
4. Whom It Useful To?
5. Limit to Loan
6. Senior Debt vs. Subordinated Debt
7. Accounting of Subordinated Debt
8. Final Words
Risk Level in Subordinated Debt
A junior debt can either be secure or unsecured. It carries a lower credit rating than
most other types of debt. It means the rate of interest would be more on such a
debt. Generally, such a debt comes with an interest rate of 13% to 25%. It may also
come with additional benefits so as to compensate the lender for the higher risk.
Because of its payment rank, this debt is riskier than other types of debt. The risk
in debt is inversely proportional to the ranking of the debt. This means that the debt
gets riskier if its rank lowers, or the risk reduces if the ranking improves. Thus, it is
very important that creditors properly evaluate the creditworthiness of the
borrower before extending the debt.

Example of Subordinated Debt

Company A has two types of debt. The first is a bond worth $5 million maturing
after 5 years, and the other is a loan from a financial company of $1 million due
after four years. Because of the coronavirus pandemic, Company A fails to operate
and had to dispose of all its assets. The court decides that the bondholders will be
eligible for the payment first. And the loan from the financial company will be paid
after that because it is a junior debt.

Types of Subordinated Debt

Following are the types of junior debt:

Bank Loan or Bond

A bond issued by a bank could be junior debt. Unlike expectations, subordinated
debt is very popular in the banking industry. It is a smart option for the banks
because interest payments are tax-deductible. A study in 1999 found that banks
issue such a debt to improve their risk level. Banks, however, generally offer such
a loan to big corporations and only after evaluating their cash flows and
creditability.

Mezzanine Debt
Mezzanine debt is also an example of junior debt. This debt ranks higher only to
the common shares of stock at the time of the payment. It is a hybrid debt.

Asset-backed Security
An asset-backed security is also a type of junior debt. A lender issues such a debt
in tranches or portions. The senior tranches rank high in terms of payment. An
example of an asset-backed security is a mortgage-backed security.
Common Stock
Common stock is another example of junior debt. Preference shares rank higher
than the common stock, while debentures rank higher than preference shares.

Whom It Useful To?

Though riskier, such a type of debt could prove very useful for small companies
seeking to grow. Since these companies are new and without much credibility, they
don’t get access to other, more secure forms of debt. However, lenders may be
willing to offer them loans but at a higher interest rate being, carrying a higher risk.
Thus, such a loan provides a small company with a chance to boost its operations.
The company taking such a loan should have consistent cash flows or be capable
of serving such a debt. Also, such a loan helps a company to save their equity for a
future sale or keep it making payments to the employees.

A junior debt may also cost less than the equity investments from outside sources.
Thus, many businesses prefer such a debt than seeking equity investment.

Limit to Loan
Even though a junior debt is useful for some companies, there is a limit to which a
company can take such a debt. Taking too much of such debt may make it difficult
for a company to service the debt and, at times, sustain its operations as well.
There are no fixed rules to determine how much debt is enough. But, there are
some measures that may give a signal about the rising debt level. These measures
are:

 Suppose a company’s total debt to EBITDA ratio is 5 to 6 times. Generally,

a senior debt makes up 2 to 3 times of debt to EBITDA. Thus, the remaining
space is for the junior debt.
 If the EBITDA to cash interest is around 2 times, then the company should
take it as a warning sign.
 If the minimum equity funding hits a 30%-35% level, it is also a warning
sign of high debt.
Senior Debt vs. Subordinated Debt
If a company liquidates its assets to pay the debt, the debt that is first in line to get
the payment is the senior debt. The debt that ranks lower in terms of payment
priority is the junior debt.Since junior debt ranks lower, they are riskier than senior
debt. Generally, senior debt is secure, while junior debt may or may not be
secured. Because they are riskier for the lender, a junior debt carries more interest
rate than senior debt.

Accounting of Subordinated Debt

Like any other debt, a junior debt is also a liability for the borrower. Therefore, like other debts
and liabilities, the subordinated debt will also be listed on the liabilities side of the balance sheet.
In the liabilities, the current liabilities come first, then comes senior or unsubordinated debt
under the long-term loans. After this, we show the junior debt on the balance sheet. When
someone gets a junior debt, their cash account increases. The loan account also goes up for the
same amount.