What is Subordinated Debt
Subordinated debt is a loan or security that ranks below other loans or securities with regard to claims on assets or earnings. Subordinated debt is also known as a junior security or subordinated loan. In the case of borrower default, creditors who own subordinated debt won't be paid out until after senior debt holders are paid in full.
Understanding Subordinated Debt
Subordinated debt is more risky than unsubordinated debt. Subordinated debt is any type of loan that's paid after all other corporate debts and loans are repaid, in the case of borrower default. Borrowers of subordinated debt are usually larger corporations or other business entities. Subordinated debt is the exact opposite of unsubordinated debt in that senior debt is prioritized higher in bankruptcy or default situations.
- Subordinated debt is debt that is repaid after senior debtors are repaid in full.
- It is riskier as compared to unsubordinated debt and is listed as a long-term liability after unsubordinated debt on the balance sheet.
Subordinated Debt: Repayment Mechanics
When a corporation takes out debt, it normally issues two or more bond types that are either unsubordinated debt or subordinated debt. If the company defaults and files for bankruptcy, a bankruptcy court will prioritize loan repayments and require that a company repay its outstanding loans with its assets. The debt that is considered lesser in priority is the subordinated debt. The higher priority debt is considered unsubordinated debt.
The bankrupt company's liquidated assets will first be used to pay the unsubordinated debt. Any cash in excess of the unsubordinated debt will then be allocated to the subordinated debt. Holders of subordinated debt will be fully repaid if there is enough cash on hand for repayment. It's also possible that subordinated debt holders will receive either a partial payment or no payment at all.
Since subordinated debt is risky, it's important for potential lenders to be mindful of a company's solvency, other debt obligations and total assets when reviewing an issued bond. Although subordinated debt is riskier for lenders, it's still paid out prior to any equity holders. Bondholders of subordinated debt are also able to realize a higher rate of interest to compensate for the potential risk of default.
While subordinated debt is issued by a variety of organizations, its use in the banking industry has received special attention. Such debt is attractive for banks because interest payments are tax-deductible. A 1999 study by the Federal Reserve recommended that banks issue subordinated debt to self-discipline their risk levels. The study's authors argued that issuance of debt by banks would require profiling of risk levels which, in turn, would provide a window into a bank's finances and operations during a time of significant change after a repeal of the Glass Steagall act. In some instances, subordinated debt is being used by mutual savings banks to buffer up their balance to meet regulatory requirements for Tier 2 capital.
Subordinated Debt: Reporting for Corporations
Subordinated debt, like all other debt obligations, is considered a liability on a company's balance sheet. Current liabilities are listed first on the balance sheet. Senior debt, or unsubordinated debt, is then listed as a long-term liability. Finally, subordinated debt is listed on the balance sheet as a long-term liability in order of payment priority, beneath any unsubordinated debt. When a company issues subordinated debt and receives cash from a lender, its cash account, or its property, plant and equipment (PPE) account, increases, and a liability is recorded for the same amount.