Definition of Subordinated Debt
Subordinated debt (also known as junior debt) is a type of unsecured debt instrument which has lower priority over senior debt instruments or other corporate debts which has higher priority, and in the event of liquidation, such subordinated debt instruments are paid only after the senior debt instruments are paid in full.
- The normal meaning of the word subordinate is “lower in ranking or position”. Debt means “a sum of money owed or due to another person”. Thus, subordinate debt is a type of debt instrument with lower priority.
- The said debt instrument has similar features to any other debt instrument, with the only exception with regards to the priority of payment. Such priority of payment is necessary only in case of liquidation of the bond-issuer. Otherwise, the debts are normally secured.
- Subordinated debt holders bear heavier risk than unsubordinated debts. This is because the holders of such instruments require a higher risk appetite. Thus, such bond holders are normally big corporate institutions. As a result, the credit rating is lower & they require a higher yield than what is paid to senior debt holders.
- The senior debt holders rank the higher priority of payment in the case of liquidation of the debtor. However, even if subordinate debts are riskier, they are paid before the settlement of equity holders of the Company. Thus, these cannot be said to be completely unsecured in nature.
- The seniority of payment can be represented through the following charts:
Image Source: http://finanium.com/seniority-ranking-of-debt-securities-in-case-of-defaults/
How Does It Work?
- The debt issuer will issue bonds with its priority ranking features. The investors will invest as per their preference & risk rating appetite.
- Big corporations will invest considering the risk involved in case the corporate issuer liquidates before maturity.
- During the period of holding bonds, the investors will receive interest from the issuer. In case no liquidation has occurred before the maturity date, all debt holders will get paid in full.
- However, in case of liquidation, the court will prioritise the outstanding loans. The court decides who will the assets first. The debts which have a lower ranking in terms of payment will be classified as subordinated debt. The bond holders who will receive first are called as priority debt holders.
Example of Subordinated Debt
Say a Corporation that operates has issued bonds with different maturity & face value. The details about the corporate issuer & its features are as follows:
|Particulars||Bond A||Bond B||Bond C|
|Payment priority before||Equity||Equity||Bond A & B|
The Company is facing financial difficulties & has an approach for liquidation of the entity. It status of the equity & liquid assets available for distribution are as follows.
|Assets of the Company available for distribution||$ 8,25,000|
|Equity Share Capital||$ 9,00,000|
Bond A & Bond B are unsubordinated bonds since they have repayment priority before equity shareholders of the entity. Bond C is the subordinated debt, as confirmed by features & higher interest rate.
The repayment schedule would be as follows:
|Available assets for distribution||$ 8,25,000|
|Less: Repaid to Bond A||$ -1,50,000|
|Less: Repaid to Bond B||$ -1,50,000|
|Net assets remaining||$ 5,25,000|
|Less: Repaid to Bond C||$ -1,20,000|
|Net assets remaining||$ 4,05,000|
|Less: Repaid to equity shareholders||$ -4,05,000|
|Loss borne by equity Shareholders||$ 4,95,000|
- Since sufficient funds are available, bond A & bond B are paid simultaneously. However, in case of insufficient funds, Bond A & Bond B would be paid on a pro-rata basis & the holders of Bond C would get nothing.
- The equity holders have to bear a loss of 55% of the amount invested at normal values.
- Thus, in any case, the subordinated bond holders get priority over equity shareholders.
Why Does Bank Issue Subordinated Debt?
- One needs to understand the difference between subordinated debt & normal debt. Normal debt holders have a normal risk rating & normal payment terms with a general charge over the assets. Normal debt is paid as & when the amount realises from the secured assets in case of liquidation of the entity. Subordinate debts bear a much higher risk. Being junior in nature, these are paid only after the senior or normal debts are paid in full.
- Banks or any other financial institutions are sensible enough to lend the hard-earned money to the corporate issuer. The lender analyses the business of the corporate entity & all the associated risk in respect of such debt. Thus, it is very clear that such debt cannot be offered to an entity with a small expansion base or small capital. Thus, the majority of subordinate debts are offered to large corporates flooded with sufficient DSCR (Debt Service Coverage Cost) & excess cashflows.
- Large corporations are flooded with super cashflows after all committed costs. The payback period is supposed to be faster for the lender to issue capital to the entity.
- Large corporations are backed by sufficient experience in the relevant field or business of the company. Thus, the corporate has seen all the ups & downs of the business cycle. Also, the lender is able to analyse the strengths, weaknesses, opportunities & threats before providing the capital amount. Thus, the provides the overall picture to the lender of everything about the corporate issuer.
- Also, the solvency ratio of the large corporation is supported by break-even ratios, sensitivity ratios with respect to adverse movement in the selling prices & primary raw material prices, critical liquidity ratios.
- Further, in the worst-case scenario, the probability of bankruptcy for a larger corporation is much lower than a business with lower capital & lower domination in the market. Above are some of the reasons why lenders offer capital in subordinated debts, even if the repayment priority is lower than normal debt.
Uses of Subordinated Debt
- Subordinated debts are sometimes issued as an obligation from the senior bond holder in respect of priority of repayment. Thus, it provides assurance to the senior bonds about the ranking in payment.
- Anyways, the bank or the financial lender received the principal amount before the preferred equity & equity shareholders.
- These can be issued as a part & parcel of a securitization debt, which is backed by assets or any collateral security.
- In few cases, the subordinated debt offers fixed monthly (in the form of dividends) if it is combined with other financial instruments.
- The cost of issue is lower for subordinated debts.
- Further, it ensures no dilution of equity holders’ stake in the Company.
- It provides flexibility to the corporate issuer in respect of payment & thus reduces the stress over debts.
- Corporates consider subordinated debts as a long-term capital solution.
- Subordinated debts also have special provisions in tax laws for benefits or exemptions.
Subordinated debt (also said to be junior debt) is risky than the unsubordinated debts or senior debts. Thus, the potential lenders should consider the existing debt obligations of the corporate issuer before providing the capital amount. However, one should note that there are various parameters checked by the lender before granting the loan amount. Also, the lender receives a higher interest rate as compared to normal debt holders due to the higher risk involved.
This is a guide to Subordinated Debt. Here we also discuss the definition and how does subordinated debt work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –