What is Subordinated Debt?
Subordinated debt, also known as junior debt or subordinated loan, is a form of debt that is considered less important than other types of debt in the event of bankruptcy.
Brief overview of Subordinated debt
When a company issues subordinated debt, it means that the lender agrees to be repaid after the company has fulfilled its obligations to senior debt holders.
Suppose the company cannot pay its debts. In that case, subordinated debt holders will only receive payment after all other creditors, including senior secured debt holders, have been paid. Hence, investing in subordinated debt is considered more risky than other types of debt.
Subordinated debt may have a variety of forms, including bonds, loans, or debentures. It generally carries higher interest rates than senior debt to compensate for the increased risk faced by investors. The higher interest rate reflects the fact that in the event of financial distress, subordinated debt holders may receive less or even no repayment.
Investors who are willing to take on higher risk in exchange for potentially higher returns might be attracted to subordinated debt.
⚠️ It is important to thoroughly assess the financial health and stability of the issuing company before investing.
Types of Subordinated Debt
There are two main types of subordinated debt: secured and unsecured.
1. Secured Subordinated Debt
Secured debt is a type of debt that is backed by collateral, such as real estate or equipment. If the borrower defaults on the debt, the lender has the right to seize and sell the collateral to recover the outstanding amount. Examples of secured debt include mortgage loans (where the home serves as collateral), auto loans (where the vehicle serves as collateral), or secured business loans (where business assets are pledged as collateral).
2. Unsecured Subordinated Debt
Unsecured debt, as the name suggests, is not backed by any specific collateral. This type of debt relies solely on the borrower’s creditworthiness and their promise to repay. In the event of default, the lender does not have a specific asset to seize and sell. Instead, the lender may take legal action to recover the debt or may engage in debt collection efforts. Common examples of unsecured debt include credit card debt, personal loans, and medical bills.
Examples of Subordinated debt
1. Subordinated bonds
Subordinated bonds are a form of debt issued by a company that is ranked lower in priority than other types of debt, such as senior secured debt and senior unsecured debt.
2. Subordinated notes
Subordinated notes are similar to subordinated bonds but have a shorter maturity date. This means that they must be repaid within a shorter period.
3. Subordinated loans
These are a form of debt that borrowers obtain from banks or other lenders. These loans are usually secured by collateral. In default, the lender can take possession of the collateral to pay off the debt. Companies may also raise funds by issuing subordinated loans. These loans have a lower priority of repayment compared to other debt obligations of the company. Subordinated loans may have fixed or variable interest rates and usually have a longer-term maturity.
4. Subordinated preferred shares
These are a type of equity a company issues. They have a higher claim on the company’s assets than common shares but a lower claim than senior preferred shares.
Learn more about Preferred Shares.
5. Convertible Subordinated Debt
This type of subordinated debt provides the holder with an option to convert the debt into equity (common shares) of the issuing company. Convertible subordinated debt offers the potential for capital appreciation if the company’s stock price rises, providing an additional benefit to the investor.
6. Mezzanine Debt
Mezzanine debt is a hybrid form of financing that combines the characteristics of both debt and equity. It is subordinated to senior debt but ranks above equity in terms of repayment priority. Mezzanine debt often includes features such as equity warrants or options, allowing lenders to participate in the company’s future growth.
7. Subordinated Debentures
Debentures are unsecured debt instruments issued by a company, and subordinated debentures rank below other debentures or debt obligations in terms of repayment priority.
Pros of Subordinated debt
- Higher interest rates: It typically pays a higher rate than other types of debt, as investors demand a higher return for taking on more risk.
- Potential for high returns: It can be a good investment for investors looking for high returns.
- Diversification benefits: Including subordinated debt in an investment portfolio can contribute to diversification. By adding an asset class with different risk characteristics, investors can reduce their overall portfolio risk.
Cons of Subordinated Debt
- Higher risk: It is considered a riskier investment than other types of debt. This is because subordinated debt holders are paid after all other creditors, including senior secured debt holders, in the event of bankruptcy.
- No collateral: It is not backed by any collateral. If the company defaults on its debt, subordinated debt holders will only be paid what is left after all other creditors have been paid.
- Can be difficult to sell: It can be challenging to sell, especially in times of economic downturn. This is because investors are less willing to take on risk when the economy is uncertain.
Subordinated debt serves as a crucial component of capital structures, contributing to the diversification and risk management strategies employed by businesses. While providing higher yields to investors, subordinated debt carries increased risk due to its lower priority of repayment in the event of insolvency. Hence, investors attracted to the potentially higher returns must carefully assess the financial health of the issuing company before proceeding.