What is Subordinated Debt?
In case of liquidation of a company, rankings are provided to various debts for the purpose of repayment, wherein the kind of debt which is ranked after all the senior debt and other corporate Debts and loans is known as subordinated debt and the borrowers of such kind of debt are larger corporations or business entities.
It is an interesting concept in the case of business. As the name suggests, the debt which is subject to subordination when the creditor’s default is called subordinated debt.
Let’s take a simple example to illustrate this.
Let’s say that you are a bank, and you have offered a subordinated debt to Company Y. After a certain period, Company Y went bankrupt. As a result, Company Y now wouldn’t be able to pay the money it has taken as a loan.
If you, as a bank, would have issued a subordinated bond, you won’t be able to claim on the company’s earnings or assets whatsoever.
You may ask – why?
Because you have issued a subordinated loan, a subordinated loan means first all the senior debts would be paid off in full from the assets and earnings of the company. After that, if anything is left, you, as a bank, would receive the money for the subordinated debt.
As you can see, the subordinated loan is pretty risky.
Every bank or financial institution that offers a subordinated bond needs to be certain about the solvency and affluence of the company before issuing subordinated bonds.
However, there’s one advantage.
Since subordinated bonds are a sort of debt, if a company defaults, the banks get the money for subordinated debts before the preferred and equity shareholders.
But still, it is better than the banks offer loans after a lot of due diligence and by looking into the cash flow, past years’ earnings, and the assets of the company. The banks should also look at important ratios like debt-equity ratio, net profit ratio, current and quick ratio, etc.
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Difference between Subordinated Debt and Unsubordinated Debt
From the name, you can already say that the subordinated bond is the complete opposite of the unsubordinated debt.
But we need to know where the actual difference lies. Let’s have a look –
- Priority: In the case of the subordinated bond, all other debts are prioritized in terms of being paid in full before the subordinated debt would be paid. However, in the case of unsubordinated debt, before any junior debts are being paid, unsubordinated debt would be paid in full first. So in regards to unsubordinated debt, the priority completely changes in terms of payment.
- Risk factor: In the case of subordinated debt, the risk is much higher for the lender. On the other hand, in the case of unsubordinated debt, the risk of the lender is pretty lower.
Understanding these two differences will make you realize how subordinated debt and unsubordinated debt work.
Which corporations take subordinated debt?
Since banks or financial institutions know that the risk is higher in lending subordinated loans, they will not offer the subordinated debt to any small business. Yes, an exception can be there, but due to the risk factor and priority factor, it is futile to offer subordinated debt to corporations.
That’s why banks / financial institutions offer subordinated debt to large corporations.
Offering subordinated loans to large corporations allow them to be safe from all ends –
- First of all, large corporations have a big cash flow and non-current assets, which will allow the banks to get paid even for a subordinated loan.
- Secondly, large corporations have seen the low and high both and overcome the trials and turbulence of business to be making huge revenue and serving a huge network of customers. This allows them to be the right partner for the subordinated loan.
- Thirdly, large corporations have better solvency than small business owners. And they may also have better financial leverage than small business owners (it can’t be known just by looking at the size of the corporation, and that’s why it’s always important for the banks to do their own due diligence before offering the subordinated bond to the corporations).
- Finally, the chances of going bankrupt for large corporations are much lower than small businesses that have just been in business for a few years. As a result, large corporations would be the most appropriate borrower of subordinated debt.
Example of Subordinated Debt
Let’s take a complete example of subordinated debt so that we can understand how it works.
Subordinated Debt Example
Y Corporation issues two types of bonds – G bond and S bond. Y is a large corporation and convinces the bank to provide both senior debt and subordinated debt. For senior debt, Y has issued a G bond, and for a subordinated bond, Y has issued an S bond. Unfortunately, Y incurs a huge loss and goes bankrupt.
Now Y Corporation has to be liquidated. Since G bond falls in the category of senior debt, it would be paid first before any other debt, preference shareholders, and equity shareholders.
However, for S bondholders, the liquidation may not be a good thing to happen because they would be given the last priority in paying off the subordinated loan. But there’s one good thing – S bondholders would get paid by the liquidation of Y Corporation before any preferred shareholders, and equity shareholder gets paid.
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Also, please do have a look at this detailed guide on Subordination debt for more examples.
Why would one become a subordinated debt holder?
This particular question may lurk in your brain – why would someone /bank /financial institution/ promoter accept a subordinated arrangement of debt.
The answer is two-fold.
First of all, when a company feels that it needs more money in the form of capital, the company approaches the companies or banks that are in a cordial relationship with them. The business relationship is such that the approached companies can’t say ‘no’ to the former company.
Secondly, due to the cordial relationship, the approached companies offer a lower rate for the debts they are offering and also a subordinated arrangement for the debt payment. In this case, the rate of interest on the subordinated loan is much lower than the rate of interest any general investors would be ready to accept.
And that’s why subordinated loan holders accept this arrangement, and it can only happen for large corporations.
Even if there can be cordial relationships between large banks and small businesses, the large banks may not take huge risks by offering subordinated debt to small businesses just for cordial relationships.
This was the guide to Subordinated Debt, its definition, Subordinated debt examples, and differences from unsubordinated debt. You may also have a look at these following articles to enhance your skills in fixed income –