What is Subordinated Debt?

Subordinated debt is a type of loan or bond that ranks below other debts in terms of repayment priority if the issuing company defaults or goes bankrupt. This means that in the event of liquidation, subordinated debt holders will be repaid only after senior debt holders have been paid in full.

Because of its higher risk, subordinated debt typically offers higher interest rates compared to senior debt. It is commonly used by businesses to raise capital while keeping senior debt levels manageable.

How Subordinated Debt Works

A company’s debt structure typically consists of:

1. Senior Debt – The first to be repaid in case of bankruptcy.
2. Subordinated Debt – Paid only after senior debt is settled.
3. Equity Holders – Shareholders receive payment only after all debts are cleared.

For example, if a company goes bankrupt and has £10 million in total debt:

• £6 million is senior debt – Paid first.
• £4 million is subordinated debt – Paid only if any funds remain after senior debt repayment.

If only £7 million is available, senior debt holders receive full repayment, while subordinated debt holders receive only £1 million of their £4 million claim, suffering a significant loss.

Types of Subordinated Debt

1. Subordinated Bonds

• Corporate bonds with lower repayment priority.
• Higher yields than senior bonds to compensate for added risk.

2. Mezzanine Debt

• A hybrid between debt and equity, often including convertible options or warrants.
• Used in private equity and leveraged buyouts (LBOs).

3. Junior Subordinated Debt

• Even lower in priority than standard subordinated debt.
• Often issued by financial institutions.

4. Perpetual Subordinated Debt

• Does not have a fixed maturity date.
• Used by banks to strengthen capital reserves.

Advantages of Subordinated Debt

• Higher Returns: Investors receive higher interest payments due to increased risk.
• Flexible Financing for Companies: Businesses can raise capital without impacting senior debt obligations.
• Tax Benefits: Interest payments on subordinated debt are tax-deductible for the issuer.
• Supports Business Growth: Used to finance expansion, acquisitions, or restructuring.

Risks of Subordinated Debt

• Higher Default Risk: Subordinated creditors are repaid only after senior creditors, increasing the risk of non-payment.
• Lower Liquidity: May be harder to sell than senior bonds.
• Potential for Loss: In bankruptcy, subordinated debt holders may lose a significant portion of their investment.

Subordinated Debt vs. Senior Debt

Feature	Subordinated Debt	Senior Debt
Repayment Priority	Lower	Higher
Interest Rates	Higher	Lower
Risk Level	Higher	Lower
Liquidity	Lower	Higher
Investor Compensation	Greater	Lower

FAQs

What is subordinated debt?

Subordinated debt is a loan or bond that ranks below senior debt in priority for repayment.

Why do companies issue subordinated debt?

It allows companies to raise capital without affecting senior debt obligations and offers tax-deductible interest payments.

How does subordinated debt differ from senior debt?

Senior debt is repaid first in bankruptcy, while subordinated debt is paid only if funds remain.

Is subordinated debt riskier than other types of debt?

Yes, it carries higher risk but compensates investors with higher interest rates.

Can subordinated debt be converted into equity?

Some subordinated debt, like mezzanine financing, includes conversion options.

Who invests in subordinated debt?

Institutional investors, hedge funds, and risk-tolerant bond investors.

Do banks issue subordinated debt?

Yes, banks issue subordinated debt to strengthen their capital structure.

What happens to subordinated debt in a bankruptcy?

It is repaid only after senior debt is settled, and in many cases, investors suffer losses.

Is subordinated debt a good investment?

It can offer higher returns, but investors must weigh the risk of default and liquidity issues.

What industries commonly use subordinated debt?

Financial institutions, private equity firms, and corporations in growth or restructuring phases.