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Subordinated bond

Category — Bond Types
A subordinated bond is a bond which in case of a debtor’s bankruptcy is paid after the payment of other higher priority bonds, the so-called senior unsubordinated bonds. Subordinated bonds are unsecured and therefore riskier than older ones.

If a company starts a bankruptcy procedure, defaults occur on all of its 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 bonds, if funds remain for this. Holders of ordinary shares receive payments last. Based on the priority of payments, subordinated bonds are also subdivided into senior subordinated, subordinated and junior subordinated bonds.

Holders of a subordinated bond may receive a higher interest rate to offset possible losses. Borrowers for subordinated bonds are most often represented by financial institutions and large corporations. Quite often issuers release parallel subordinated and senior bonds. Banks often issue subordinated bonds to meet Tier II capital requirements rather than for 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. In some cases, this 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.

The corporate sector, on the other hand is exempt from compulsory compliance with these rules, its securities are classified as hybrid. Nevertheless, corporate hybrid securities follow the criteria of the rating agencies 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 and diversify financing, and refinance existing hybrid issues.
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