Subordinated bond

What are subordinated bonds?

A subordinated bond is a type of bond that receives payment only after other higher-priority bonds, known as senior unsubordinated bonds, have been paid in the event of a debtor’s bankruptcy. These subordinated bonds are unsecured, making them riskier compared to older, higher-priority bonds.

Understanding subordinated bonds

If a company, a bank, or financial institution starts a bankruptcy procedure, defaults occur on all of its debt obligations. The bankruptcy court assigns the company’s debts according to the priority of payments and requires the company to pay off existing debt according to the available assets. First, payments are due to holders of preferred shares, then payments will be made for senior unsubordinated bonds and tax arrears. Then come payments on subordinated debt instruments if funds remain for this. Holders of ordinary shares receive payments last. Based on the priority of payments, the subordinated bond is also subdivided into senior subordinated, subordinated, and junior subordinated bonds.

Holders of a subordinated bond, who financial institutions and large corporations may represent, may receive a higher interest rate to offset possible losses. Quite often, issuers release parallel subordinated and senior bonds, with banks utilizing subordinated bonds to meet Tier II capital requirements rather than for debt financing purposes (as in the case of senior bonds). The issuance of a subordinated bond, in this case, is a cheaper solution than capitalization of equity capital, and in some cases, it allows for tax deductions in the most favored regulatory regime.

From the perspective of the issuer, the structure of subordinated bonds is well-defined and harmonized under the new regulations Basel III (for banks) and Solvency II (for insurers). Another type of subordinated securities is the so-called Contingent Convertibles, which could be converted into equity in case of a certain event. The analogue of these bonds for insurance companies are RT1 bonds issued to meet capital requirements under Solvency II. Conditional convertible bonds most often can be redeemed after a certain number of years at par, or the coupon will be refixed for a future period of time.

On the other hand, the corporate sector is exempt from compulsory compliance with these rules; its securities are classified as hybrid. Nevertheless, corporate hybrid securities follow the rating agencies’ criteria, and they are a relatively homogeneous asset type. According to the rating agencies’ methodology, hybrid securities are partially taken into account as equity when calculating the credit rating; accordingly, the purpose of issuing hybrid securities is to improve their credit rating, reduce costs, diversify financing, and refinance existing hybrid issues.

If a company defaults or faces bankruptcy, the payment priority follows a structured approach, with senior lenders having the highest priority to get paid in full, followed by other corporate debts and obligations. The company’s solvency, capital stack, and total assets and liabilities play crucial roles in such scenarios. Moreover, unsecured loans, outstanding debts, and unsecured borrowing arrangements can further impact the company’s financial situation. Regulatory requirements and bank regulations also have implications on the company’s financial decisions and payment priorities. Throughout this process, potential lenders and equity holders are carefully assessing the company’s situation, as the payment priority and the risk profile of the company’s debts determine their chances of being paid back in full. Deposit obligations are also subject to consideration and could impact the company’s financial position and bankruptcy procedures.

Difference between subordinated and senior bonds

Senior bond, being at the highest priority in the repayment order, is considered the least risky form of debt, leading to its association with lower interest rates. Banks typically finance it, which holds a lower-risk status in the repayment hierarchy due to their access to low-cost funding from deposit and savings accounts. Banking regulators advocate for a lower-risk loan portfolio, further supporting the position of senior debt as a safer investment.

On the other hand, subordinated bond holds a lower position in the repayment order compared to senior debt. This characteristic results in higher interest rates for subordinated bonds due to the increased risk associated with its repayment. Nevertheless, the subordinated bond still maintains a higher priority compared to preferred and common equity. Various types of subordinated bonds exist, including mezzanine debt, which combines debt with an investment component. Additionally, asset-backed securities often incorporate a subordinated feature, where certain tranches are considered subordinate to senior tranches. Asset-backed securities represent financial instruments backed by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables. The use of tranches divides risk and group characteristics, making them appealing to different investors.

Both banks and financial institutions often issue subordinated debt, and they act as subordinated lenders. When a company faces bankruptcy, the payment priority determines the order in which debts and obligations are settled, with senior debtors receiving priority. Subordinated debt holders are further down the repayment order.

From an investor’s perspective, subordinated bonds’ risk profile is higher than senior debt, making senior bondholders enjoy lower risk and potentially lower interest rates. For larger corporations and business entities, subordinated bonds may serve as a way to secure additional funding while understanding the associated risk. Additionally, the tax deductibility of interest payments on subordinated bonds can be advantageous to the issuing company.

Financial institutions closely manage their balance sheets and consider the regulatory environment, adhering to bank regulations and any subordination agreements. Furthermore, investment advisers often guide companies’ financial decisions and consider the company’s overall financial health.

Both senior and subordinated debts are classified as long-term liabilities on a company’s balance sheet. However, when a company faces bankruptcy, senior debt is prioritized for repayment over subordinated debt, making it less likely to file for bankruptcy.

Examples of subordinated bonds

Subordinated bond encompasses various examples, such as mezzanine debt, which incorporates an investment component. Moreover, asset-backed securities often exhibit a subordinated feature, wherein certain tranches are considered subordinate to senior tranches.

What is subordinated debt?

In finance, subordinated debt, referred to as subordinated loan, subordinated bond, subordinated debenture, or junior debt, represents a debt that holds a lower priority compared to other debts in the event of a company facing liquidation or bankruptcy.

Types of subordinated debt

Subordinated debt comprises several types, arranged in descending order of priority: high-yield bonds, mezzanine (with and without warrants), Payment in Kind (PIK) notes, vendor notes, and other debt obligations. An alternative approach to represent the varying priorities of securities is through a subordination scale, where high-yield bonds hold the least subordination, and vendor notes possess the highest level of subordination.