Subordinated bond

What is a subordinated bond?

A subordinated bond is a type of bond where the bondholder is at the bottom of the repayment hierarchy if the borrowing company faces bankruptcy. This means that in such a situation, other loans with higher priority, known as senior unsubordinated bonds, get paid off before the subordinated bondholders receive their payments. In other words, the subordinated bonds are riskier to hold 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 of all, payments are due to the holders of preferred shares. Secondly, payments will be made for senior unsubordinated bonds and tax arrears. Then, holders of the subordinated debt instruments will receive payment. Finally, if funds still remain, holders of ordinary shares will be paid. Based on the payment priority, the subordinated bond is further subdivided into senior subordinated, subordinated, and junior subordinated bonds.

Holders of subordinated bonds, for example, 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. Banks utilize 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. Moreover, it often 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 regime. 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.

In contrast, the corporate sector does not have to strictly follow these rules; since its financial instruments are classified as hybrid. However, corporate hybrid securities follow the rating agencies’ criteria, and they are a rather similar in terms of their characteristics. According to the rating agencies’ methodology, hybrid securities are partially considered 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 is considered the safest type of debt because it is the first in line to be repaid if a company faces bankruptcy. This lower risk makes it possible for senior bonds to have lower interest rates. Banks typically purchase such securities due to their access to low-cost funding from deposits and savings accounts. Additionally, regulators encourage banks to have safer loan portfolios, which reinforces the position of senior debt as a secure investment.

On the other hand, subordinated bond is in a lower position in the repayment order compared to senior debt. This means it carries more risk, and as a result, it tends to have higher interest rates. However, it’s important to note that subordinated bonds still have a higher priority for repayment compared to preferred and common equity.  

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 are riskier compared to senior debt. This means that senior bondholders face less risk and, as a result, tend to receive lower interest rates on their investments. For larger corporations and business entities, subordinated bonds can be a way to secure additional yield, even though they are aware of the higher risk involved. Moreover, the tax deductibility of interest payments on subordinated bonds can be advantageous for the issuing company.

Financial institutions attentively 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.

Mezzanine debt is a type of financing that falls between senior secured debt and equity in a company’s capital structure. It is typically subordinated to senior debt, which means it has a higher level of risk but also offers higher potential returns for investors. Mezzanine debt often combines elements of both debt and equity, featuring interest payments like traditional loans but also potentially convertible into equity if certain conditions are met, making it an attractive option for businesses seeking flexible financing solutions.

Additionally, asset-backed securities often incorporate a subordinated feature as 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, which makes such securities attractive to a broader range of investors.