The difference between subordinated debt and senior debt is the priority in which the debt claims are paid by a firm in bankruptcy or liquidation. If a company has both subordinated debt and senior debt and has to file for bankruptcy or faces liquidation, the senior debt is paid back before the subordinated debt. Once the senior debt is completely paid back, the company then repays the subordinated debt.

Subordinated Debt Risk

There is the risk that a company is not able to pay back its subordinated or junior debt due to the fact it uses what money it does have during liquidation to pay senior debt holders. Therefore, it's often considered more advantageous for a lender to own a claim on a company's senior debt than on subordinated debt.

In addition, senior debt is often secured. Secured debt is debt secured by the assets or other collateral of a company and can include having liens and claims on certain assets.

Senior Versus Subordinated Debt

If a company files for bankruptcy, the bankruptcy courts prioritize the outstanding loans in which the company's liquidated assets are used to repay. Any debt that has a lesser priority over other forms of debt is considered subordinated debt. Any debt with higher priority over other forms of debt is considered senior debt.

For example, a company has debt A that totals $1 million and debt B that totals $500,000. Debt A is senior debt and debt B is subordinated debt. If the company needs to file for bankruptcy, it is required to liquidate all of its assets to repay the debt. If the company's assets are liquidated for $1.25 million, it first needs to pay off the $1 million amount of its senior debt A. The remaining subordinated debt B is only half repaid due to the lack of money.

Debt Hierarchy

Senior debt has the highest priority and therefore the lowest risk. Thus, this type of debt typically carries or offers lower interest rates. Meanwhile, subordinated debt carries higher interest rates given its lower priority during payback.

Senior debt is generally funded by banks. The banks take the lower risk senior status in the repayment order because they can generally afford to accept a lower rate given their low-cost source of funding from deposit and savings accounts. In addition, regulators advocate for banks to maintain a lower risk loan portfolio.

Subordinated debt is any debt that falls under, or behind, senior debt. However, subordinated debt does have priority over preferred and common equity. Examples of subordinated debt include mezzanine debt, which is debt that also includes an investment. Additionally, asset-backed securities generally have a subordinated feature, where some tranches are considered subordinate to senior tranches.

Who Issues Subordinated Debt?

One of the benefactors of subordinated debt is banks. Banks generally raise subordinated debt when rates on these loans are lower than other forms of raising capital. This comes as many banks are considered low-risk given the increased regulatory scrutiny since the financial crisis of 2008-2009. Subordinated debt has become a relatively easy way for banks to meet capital requirements without having to dilute its shareholder base by raising capital.