You may have come across the term “subordinated debt” but what exactly is it? Subordinated debt is a type of debt that ranks lower in priority than other forms of debt in the event of a company’s bankruptcy or liquidation. If a company runs into financial trouble, subordinated debt holders may be the last to receive or may not receive payment at all.  

Despite the increased risk associated with subordinated debt, it can offer attractive benefits to investors, such as higher interest rates and potential tax advantages. Several types of subordinated debt, including subordinated bonds, subordinated loans, and mezzanine debt, each with its characteristics and features.  

To better understand subordinated debt, let’s take a closer look at its definition, the different types of subordinated debt, and an example of how it works in practice. 

How is subordinate debt used?  

Now as we have understood what is subordinated debt, it’s time to dive in and look into how subordinated debt is used.  Subordinate debts are often issued as a bond or notes and have a fixed maturity date, just like other types of debt. However, investors consider subordinated debt riskier, as they are paid after senior debt holders and may only be paid in full if the company can meet its obligations.  

One of the main advantages of subordinated debt is that it can be less expensive for the issuer compared to other types of financing, such as equity or senior debt. This is because subordinated debt holders take on more risk, expecting a higher return on their investment.  

Subordinated debt can also be used to manage a company’s capital structure. By issuing subordinated debt, a company can improve its debt-to-equity ratio without diluting the ownership of existing shareholders. This can make the company more attractive to investors and lenders, which can help to lower borrowing costs.  

Overall, subordinated debt can be a useful financing tool for companies, but it is important to consider the risks and benefits before deciding to issue it.  

What are the types of subordinated debts?  

There are several types of subordinated debts, which include:  

Junior Subordinated Debt

This is a type of subordinated debt issued by a company and is subordinate to all other types of debt issued by the company. This type of debt is typically issued with a long-term maturity and often has a fixed or floating interest rate.  

Mezzanine Debt

This subordinated debt is typically used to finance mergers, acquisitions, and leveraged buyouts. Mezzanine debt typically yields higher than senior debt but lower than equity. It is often structured as a combination of debt and equity, with the debt portion having a subordinate position to other forms of debt.  

Convertible Debt

This subordinated debt can be converted into equity in the issuing company later. Convertible debt typically has a lower interest rate than other types of debt, as it offers the potential for a higher return through equity conversion.  

Subordinated Debentures

This type of subordinated debt is typically issued by a corporation and is secured by a lien on its assets. Subordinated debentures are subordinate to all other types of debt issued by the corporation and have a higher yield than other types of debt.  

Unsecured Subordinated Debt

This type of subordinated debt is not secured by any assets and is subordinate to other types of debt. Unsecured subordinated debt often has a higher yield than other types of debt to compensate for the increased risk.  

What is the risk level of subordinated debts?  

A “risk level” of subordinated debts refers to the degree of risk involved in investing in this type of debt. Subordinated debts are debts that have a lower priority than other debts in the event of default or bankruptcy. If a company or individual cannot pay off all of its debts, subordinated debts are typically paid off after other, higher-priority debts are paid.  

The risk level of subordinated debts is generally higher than other debts because of this lower priority in repayment. Investors who purchase subordinated debt are taking on a higher level of risk because they may not receive payment in full or may not receive payment at all in the event of default.  

In addition to the risk of default, subordinated debts may be subject to other risks, such as interest rate and liquidity risks. Interest rate risk refers to the risk that the value of the debt will decline as interest rates rise, while liquidity risk refers to the risk that the debt will be difficult to sell or trade if the investor needs to exit the investment quickly.  

Perks of subordinate debts 

Subordinate debts refer to debts or loans with a lower priority of payment than other debts or loans in case of bankruptcy or default. Some of the perks of subordinate debts include:  

Lower interest rates

Subordinate debts typically have a higher risk because they are lower in priority for payment, so lenders may charge a lower interest rate than they would for higher-priority debts.  

Access to capital

Subordinate debts can be a useful source of capital for companies or individuals who may need help to obtain loans from other sources due to their credit history or other factors.  

Flexible terms

Subordinate debts can have more flexible terms than other types of debt, such as longer repayment periods or more lenient collateral requirements.  

Potential for higher returns

Although subordinate debts carry higher risk, they can also offer higher returns to investors willing to take on that risk.  

Improved credit rating

If a borrower successfully pays off their subordinate debt, it can help improve their credit rating and make it easier for them to obtain credit in the future.  

Conclusion   

In conclusion, subordinated debts are an important part of the financial market that offers investors different types of securities, such as subordinated bonds and preferred stocks. These types of debts are considered riskier than other forms of debt as they are paid back after other creditors in the event of a default. However, the risk level of subordinated debts varies depending on the issuer’s creditworthiness, the nature of the securities, and the specific terms of the offering. Despite the higher risk, subordinated debts offer some perks to investors, such as higher yields and potentially higher returns. They can also provide diversification benefits to a portfolio, particularly for investors seeking exposure to riskier assets. 

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Wajiha Danish

Wajiha Danish is the Director at Monily, overseeing financial strategies and operations for small and medium businesses. She has over 18 years of experience, including her role as Controller at HOCHTIEF PPP Solutions North America. Wajiha's background includes significant roles at Pakistan Petroleum Limited and A.F. Ferguson & Co. (PwC Pakistan). She is a Chartered Certified Accountant (ACCA) and Certified General Accountant (CGA) with expertise in financial management and project finance.