Table of Contents
- What Are Netting Escrows & How Does It Work?: The Best Guide - January 2, 2024
- The Secret About Prescriptive Easement: Top Guide 1 Must Know - December 4, 2023
- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
About Subordinated Debt
When an unsecured loan or bond is rated below other more senior loans or securities in regards to claims on assets or earnings they are termed as Subordinated debt. Subordinated debentures is another name for Subordinated debt.
They are also known as junior securities. In the event of defaulting by the borrower, the creditors who own subordinated debt will have to wait until after the senior bondholder’s payment is done in full.
Knowing Subordinated Debt
In comparison to unsubordinated debt, a subordinated debt is riskier. In the event of a borrower defaulting then the subordinated debts are loans that are paid after all other corporate debts and loans are repaid.
Usually, larger corporations and other business entities are the borrowers of subordinated debt. The subordinated loan is not the same as senior debt, because senior debt is a priority during the event of bankruptcy or default situations.
The Process of Repayment of Subordinated Debt
During the process of taking out debt, a corporation usually issues two or more bond types that are either unsubordinated debt or subordinated debt.
In case of default and the company files for bankruptcy, then a bankruptcy court will prioritize loan repayments and would want the company to repay its outstanding loans with its assets.
The debt which is lesser in priority is the subordinated debt and the higher priority debt is known as unsubordinated debt.
The bankrupt company’s liquidated assets will go first in paying off the unsubordinated debt. Any excess cash of the unsubordinated debt will then be given out to the subordinated debt.
Subordinated debt holders will be repaid fully only if there is enough cash in hand for repayment. There is also a possibility that the holders of subordinated debt will receive either a partial payment or no payment at all.
When reviewing an issued bond it’s important for potential lenders to be aware of a company’s solvency, their other debt obligations, and total assets because giving out subordinate loans is risky.
Even if the subordinated debt is riskier for lenders, they still get paid out before the payment to any equity holders. To compensate for the potential risk of default bondholders of subordinated debt are also able to realize a higher rate of interest.
A variety of organizations issue subordinated debt, but its use in the banking industry has received special attention. Because the interest payments are tax-deductible subordinated debt is attractive for banks.
In 1999 the Federal Reserve recommended that banks issue subordinated debt to self-discipline their risk levels, after making a deep study.
According to the study’s authors issuance of debt by banks would require profiling of risk levels which, in turn, would give an opportunity to a bank’s finances and operations during a time of significant change. In some cases, mutual savings banks use subordinated debt to cushion up their balance to meet regulatory requirements for Tier 2 capital.
Subordinated Debt for Companies
Like any other debt obligation, a subordinated debt is treated as a liability on a company’s balance sheet. In the balance sheet, current liabilities are listed first. Then in the list comes senior debt or unsubordinated debt, as a long-term liability.
Finally, as a long-term liability in order of payment priority, under the unsubordinated debt, subordinated debt is listed on the balance sheet.
Difference between Subordinated Debt vs Senior Debt
Depending on the priority in which the debt claims are paid by a firm in bankruptcy or liquidation one can know the difference between subordinated debt and senior debt.
In case an organization needs to file for bankruptcy or face liquidation and has both subordinated loan and senior debt then before the subordinated debt the senior debt is paid off. Only after the senior debt is completely paid, the company repays the subordinated debt.
As senior debt is of the highest priority, they have the lowest risk. Hence this type of debt offers lower interest rates.
Whereas subordinated debt carries higher interest rates because of its lower priority during payback.
Banks generally fund senior debt. In the repayment order, the banks take the lower risk because they can generally afford to accept a lower rate as the source of their funding is from deposit and savings accounts resulting in low cost.
Along with that regulators recommend for banks to maintain a lower risk loan portfolio.
Conclusion
A debt that is repaid only after senior debtors are repaid in full is called subordinated debt.
Compared to unsubordinated debt a subordinated debt is riskier and on the balance sheet, it shows as a long-term liability after unsubordinated debt.
Any debt that falls under, or behind, senior debt is subordinated debt. Subordinated debt has priority over preferred and common equity. Mezzanine debt, which is debt that also includes an investment is an ideal example of subordinated debt.
