In
finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts if a company falls into
liquidation or
bankruptcy.
Such debt is referred to as 'subordinate', because the debt providers (the lenders) have subordinate status in relationship to the normal debt.
Subordinated debt has a lower priority than other bonds of the issuer in case of
liquidation during
bankruptcy, and ranks below: the
liquidator, government tax authorities and
senior debt holders in the hierarchy of creditors. Debt instruments with the lowest seniority are known as subordinated debt instruments.
Because subordinated debts are only repayable after other debts have been paid, they are more risky for the lender of the money. The debts may be secured or unsecured. Subordinated loans typically have a lower
credit rating
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
, and, therefore, a higher
yield than senior debt.
A typical example for this would be when a promoter of a company invests money in the form of debt rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves), the promoter would be paid just before stockholders — assuming there are assets to distribute after all other liabilities and debts have been paid.
While subordinated debt may be issued in a public offering, major
shareholders and
parent companies are more frequent buyers of subordinated loans. These entities may prefer to inject capital in the form of debt, but, due to the close relationship to the issuing company, they may be more willing to accept a lower rate of return on subordinated debt than general investors would.
Examples
A particularly important example of subordinated bonds can be found in bonds issued by banks. Subordinated debt is issued periodically by most large banking corporations in the U.S. Subordinated debt can be expected to be especially
risk
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environm ...
-sensitive because subordinated debt holders have claims on bank assets only after senior debtholders and they lack the upside gain enjoyed by shareholders.
This status of subordinated debt makes it perfect for experimenting with the significance of
market discipline
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy. This means, in order to meet economic necessity, buyers must avoid p ...
, via the signalling effect of secondary market prices of subordinated debt (and, where relevant, the issue price of these bonds initially in the primary markets).
From the perspective of policy-makers and regulators, the potential benefit from having banks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the "supervision" of the financial condition of the banks. This, hopefully, creates both an early-warning system, like the so-called "canary in the mine", and, also hopefully, an incentive for bank management to act prudently, thus helping to offset the
moral hazard
In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...
that can otherwise exist, especially in a circumstance where banks have limited equity and deposits are insured. This role of subordinated debt has attracted increasing attention from policy analysts in recent years.
[See, e.g., "Subordinated debt: a capital markets approach to bank regulation." Mark E. Van Der Weide and Satish M. Kini. Boston College Law Review. Volume 41, number 2. March 2000.]
For a second example of subordinated debt, consider asset-backed securities. These are often issued in
tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see indenture) ...
s. The senior tranches get paid back first; the subordinated tranches later.
A third example is
mezzanine debt.
Use
Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as in the issue of
asset-backed securities,
collateralized mortgage obligations or
collateralized debt obligation
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).Le ...
s. Corporate issuers tend to prefer not to issue subordinated bonds because of the higher interest rate required to compensate for the higher risk, but may be forced to do so if indentures on earlier issues mandate their status as senior bonds.
Also, subordinated debt may be combined with
preferred stock
Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt inst ...
to create so-called
monthly income preferred stock Monthly income preferred stock or MIPS is a hybrid security created by Eli Jacobson, a Sullivan & Cromwell tax partner, and introduced to the market by Goldman Sachs in 1993. In essence, MIPS is a combination of deeply subordinated debt and preferre ...
, a
hybrid security
Hybrid securities are a broad group of securities that combine the characteristics of the two broader groups of securities, debt and equity.
Hybrid securities pay a predictable (either fixed or floating) rate of return or dividend until a certai ...
paying dividends for the lender and funded as interest expense by the issuer.
See also
*
Tier 2 capital Tier 2 capital, or supplementary capital, includes a number of important and legitimate constituents of a bank's capital requirement.By definition of Bank for International Settlements. These forms of banking capital were largely standardized in t ...
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Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III.
The Basel II Accord was publ ...
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Bank condition
The CAMELS rating is a supervisory rating system originally developed in the U.S. to classify a bank's overall condition. It is applied to every bank and credit union in the U.S. and is also implemented outside the U.S. by various banking supervi ...
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Banking regulation
Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom the ...
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CAMELS rating
The CAMELS rating is a supervisory rating system originally developed in the U.S. to classify a bank's overall condition. It is applied to every bank and credit union in the U.S. and is also implemented outside the U.S. by various banking supervi ...
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Perpetual subordinated debt
Perpetual subordinated debt is debt (bonds) with no maturity date for the return of principal, never needs to be redeemed by the issuer, and thus pay coupon interest continually until bought back (hence, "perpetual"). Like other subordinated debt, ...
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Structural subordination In corporate finance, structural subordination is the concept that a lender to a company will not have access to the assets of the company's subsidiary until after all of the subsidiary's creditors have been paid and the remaining assets have been d ...
References
External links
* http://www.anz.com/edna/dictionary.asp?action=content&content=subordinated_loan
List of companies providing subordinated debt financingStructural Subordination
{{DEFAULTSORT:Subordinated Debt
Credit
Bonds (finance)
Debt