What Is Subordinated Debt? Definition and Risks

Search Fintrev

Search our guides, reviews and glossary.

Subordinated debt is a loan or bond that ranks below other debt in its claim on a borrower’s assets or earnings. If the borrower defaults, goes bankrupt or is liquidated, holders of subordinated debt are repaid only after senior creditors have been paid in full. Because it sits lower in line, it is also called junior debt, and when it takes the form of an unsecured bond it is usually called a subordinated debenture. Lenders accept that weaker position in exchange for a higher interest rate than senior debt of the same issuer pays.

How Subordinated Debt Works

A company that borrows often issues more than one class of debt. Some is unsubordinated (senior), and some is subordinated. The ranking is set in the loan agreement or bond indenture, sometimes backed by a separate subordination agreement in which one creditor formally agrees to stand behind another.

While the company is healthy, the ranking has little visible effect: both classes receive scheduled interest, and the subordinated class earns a higher rate. The ranking matters when the company cannot pay everyone. In a bankruptcy, the court applies the priority of claims, and the company’s assets repay outstanding obligations in order. A simplified version of that order:

1. Secured senior creditors, up to the value of their collateral
2. Other senior (unsubordinated) creditors
3. Subordinated creditors, including junior subordinated debt at the bottom of the debt stack
4. Preferred shareholders
5. Common shareholders

Real bankruptcies are messier. Administrative costs and certain priority claims, such as some taxes and employee wages, are paid ahead of general creditors, and negotiated Chapter 11 plans can produce outcomes that differ from a strict ranking. The basic rule still holds: subordinated creditors are repaid after senior creditors and before equity holders.

Example of Subordinated Debt

In this hypothetical example, which ignores administrative costs and other priority claims, a company owes $50 million of senior debt and $30 million of subordinated debt and is liquidated.

Scenario A: liquidation produces $70 million.

• Senior creditors receive the full $50 million.
• The remaining $20 million goes to subordinated creditors, who recover $20 million of $30 million, or about 67%.
• Shareholders receive nothing.

Scenario B: liquidation produces $45 million.

• Senior creditors receive all $45 million, recovering 90% of their claim.
• Subordinated creditors receive nothing, a 100% loss.
• Shareholders receive nothing.

A $25 million drop in liquidation value cost senior lenders only 10% of their claim but wiped out the subordinated lenders entirely. That asymmetry is why subordinated debt pays a higher rate.

Why Companies and Banks Issue Subordinated Debt

Cheaper than equity. For the issuer, subordinated debt costs more than senior debt but usually less than issuing new shares. In the United States, interest on business debt is generally tax-deductible (subject to limits), while dividends are not. It also lets a company raise capital without diluting existing owners.

Room for more borrowing. Senior lenders often prefer that additional borrowing rank behind them. Issuing subordinated debt can let a company add leverage while leaving senior lenders’ protection intact.

Bank regulatory capital. Qualifying subordinated debt can count toward a bank’s Tier 2 capital, the supplementary layer that absorbs losses after core capital. Some mutual savings banks, which cannot issue common stock in the usual way, have used it to build up capital and meet regulatory requirements. A 1999 Federal Reserve study recommended that banks issue subordinated debt as a form of market discipline: because its buyers bear real loss risk, they have reason to scrutinize a bank’s risk profile, and their pricing gives regulators and the public a window into the bank’s condition.

Structured finance. Asset-backed securities, which are backed by pools of loans, leases, credit card debt, royalties or receivables, are usually split into tranches. Subordinated tranches take losses before senior tranches, which lets the senior tranches carry lower risk and appeal to more conservative investors.

Forms of Subordinated Debt

• Subordinated debentures: unsecured bonds that rank below the issuer’s senior debt.
• Junior subordinated debt: debt ranked below the issuer’s other subordinated debt, often with features such as the ability to defer interest. Banks have historically used junior subordinated debentures to back trust preferred securities.
• Mezzanine debt: subordinated financing that often includes an equity component, such as warrants or conversion rights, common in buyouts and growth financing.
• Subordinated tranches in asset-backed securities and other securitizations.
• Subordinated shareholder or owner loans: a business owner lends to the company and agrees to rank behind bank lenders, which can make outside lenders more willing to extend credit.

How Subordinated Debt Appears on the Balance Sheet

Subordinated debt is a liability like any other debt. Current liabilities are listed first; long-term liabilities follow, with senior debt typically shown ahead of subordinated debt in line with payment priority. Subordinated debt also counts in total and net debt when analysts calculate enterprise value.

Distinctions Readers Often Confuse

Subordinated vs. senior debt. The core difference is priority. Senior debt is repaid first, carries less risk and pays lower interest. It is often provided by banks, whose low-cost deposit funding and regulatory push toward lower-risk loan books let them accept lower rates.

Debenture vs. subordinated debenture. A debenture is an unsecured bond backed by the issuer’s general credit. A senior debenture ranks alongside other senior unsecured debt; a subordinated debenture ranks below it.

Subordinated vs. unsecured. These are separate ideas. “Secured” means backed by specific collateral; “subordinated” means lower rank. Most subordinated bonds are unsecured, but a loan can be both: a second mortgage or second-lien loan is secured by collateral yet ranks behind the first lien.

Subordinated debt vs. preferred stock. Both sit between senior debt and common equity, but subordinated debt is still debt: missed interest is generally a default, and its holders rank ahead of all preferred and common shareholders.

Limitations and Risks

For investors, the main risk is low or zero recovery in default. Recovery depends on asset values that are hard to predict in a distressed sale, and the more senior debt a company carries, the thinner the cushion below. Judging that risk means looking at the issuer’s solvency, its total debt and the assets available to repay it, not only the coupon. For issuers, the higher rate raises funding costs, and lenders may demand covenants or other protections in return.

FAQs

The Bottom Line

Subordinated debt matters to bond investors weighing a higher yield against the chance of little or no recovery in default, and to companies and banks seeking capital that costs less than new shares. Investors should judge an issuer's solvency, total debt and available assets rather than the coupon alone. Issuers should expect higher funding costs and possible covenant demands from lenders.