What Is the Difference Between Subordinated Debt and Senior Debt?
The difference between subordinated debt and senior debt is the priority in which a firm in bankruptcy pays the debt claims. If a company has both subordinated debt and senior debt and has to file for bankruptcy or face 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 and senior debt differ in terms of their priority if a firm faces bankruptcy or liquidation.
- Subordinated debt, or junior debt, is less of a priority than senior debt in terms of repayments.
- Senior debt is often secured and is more likely to be paid back while subordinated debt is not secured and is more of a risk.
Understanding the Two Types of Debt
The fundamental implications of the two types of debt are the risk to the creditor.
With subordinated debt, there is a risk that a company cannot pay back its subordinated or junior debt if it uses what money it does have during liquidation to pay senior debt holders. Therefore, it is often more advantageous for a lender to own a claim on a company's senior debt than on subordinated debt.
When a company files for bankruptcy, the issuers of senior debt, typically bondholders or banks that have issued revolving lines of credit, have the best chance of being repaid. Next in line are junior debt holders, preferred stockholders, and common stockholders. In some cases, these parties are paid by selling collateral that has been held for debt repayment.
Example of Subordinated Debt vs. Senior Debt
If a company files for bankruptcy, the bankruptcy courts prioritize the outstanding loans that must be paid using the company's liquidated assets.
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 files for bankruptcy, it must liquidate all of its assets to repay the debt. If the company's assets are liquidated for $1.25 million, it must first pay off the $1 million amount of its senior debt A. Only half of the remaining subordinated debt B is repaid due to the lack of funds.
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.
Banks typically fund senior debt. Banks assume lower risk senior status in the repayment order because they can afford to accept a lower rate given their low-cost sources 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. Asset-backed securities are financial securities collateralized by a pool of assets, including loans, leases, credit card debt, royalties, or receivables. Tranches are portions of debt or securities that have been designed to divide risk or group characteristics so that they can be marketable to different investors.
One of the benefactors of subordinated debt is banks. Banks 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 to 2009. Subordinated debt has become a relatively easy way for banks to meet capital requirements without having to dilute their shareholder base by raising capital.