Understanding Subordinated Debt: What it is and How it Works

Introduction:

When thinking about investing in a company, many people only consider its equity. However, an important type of investment that is often overlooked by investors is subordinated debt. Subordinated debt is a type of debt that is paid back after other types of debt, such as senior debt, in the case of bankruptcy or insolvency. In other words, subordinated debt holders have less priority than other creditors in a business’s capital structure.

In this article, we will delve into the details of subordinated debt, how it works, and why it is an important tool for businesses and investors alike.

What is Subordinated Debt?

Subordinated debt, also known as junior debt or mezzanine debt, is a type of debt that is placed lower in the capital structure of a company than other types of debt. This means that if the company were to go bankrupt or become insolvent, subordinated debtholders would be paid back after other creditors.

To better understand this, let us take a look at a company’s capital structure. A company’s capital structure is the mix of debt and equity financing used to fund its operations. In a typical capital structure, senior debt holders, such as banks and bondholders, are at the top of the hierarchy and are first in line to receive payment if the company were to experience financial difficulty. Next in line are junior debt holders, such as subordinated debtholders, followed by preferred stockholders and lastly common stockholders.

Subordinated debt usually pays a higher interest rate than other types of debt because of its lower priority in the capital structure. It is also usually unsecured, meaning that it is not backed by any collateral. This makes it riskier for investors but can be an attractive option for businesses looking for financing without having to provide collateral.

How Does Subordinated Debt Work?

Subordinated debt can come in different forms and structures, including bonds, convertible bonds, and preferred shares. Let us take a closer look at each one.

Bonds:

Subordinated bonds are a type of debt that ranks below senior debt in a company’s capital structure. They have a lower credit rating than senior debt, and as a result, pay a higher interest rate to compensate investors for taking on additional risk.

Convertible Bonds:

Convertible bonds are a type of subordinated bond that can be converted into equity if certain conditions are met. In this case, investors can benefit from both the higher interest rate paid by subordinated debt and the potential for capital appreciation if the company’s stock price increases.

Preferred Shares:

Preferred shares are a type of equity investment that can also be considered subordinated debt. Preferred shares pay a fixed dividend to investors, similar to bond interest payments, but also offer the potential for capital appreciation if the company’s stock price rises. In the event of bankruptcy, preferred shareholders are typically repaid before common shareholders, but after all types of debt have been paid.

Why Do Companies Choose Subordinated Debt?

Businesses often choose subordinated debt for several reasons. First, subordinated debt can be cheaper than other types of debt or equity financing. This is because it is riskier for investors and therefore requires a higher interest rate to compensate.

Second, subordinated debt can provide flexibility for companies in terms of their capital structure. By using subordinated debt, companies can avoid diluting existing equity holders while still raising the funds they need to finance their operations or growth.

Third, subordinated debt can help companies take advantage of growth opportunities that may not be available through other types of financing. This is because subordinated debt is often unsecured and does not require collateral, which can be difficult for young or growing companies to provide.

The Risks of Subordinated Debt

While subordinated debt can provide additional funding options for businesses and investment opportunities for investors, it is not without its risks. As mentioned, subordinated debt is lower in the capital structure and therefore carries more risk than other types of debt or equity. In the event of bankruptcy or insolvency, subordinated debtholders are the last to be paid and may not receive any payment at all.

Moreover, subordinated debt is often unsecured, meaning that it is not backed by any collateral. This makes it riskier for investors, as it reduces their chances of recovering their investment in the event of default.

It is also important to consider the creditworthiness of the business issuing the subordinated debt. A business with a weaker credit rating is more likely to default on its debt obligations and may not be able to make payments on the subordinated debt as well.

Government Stats on Subordinated Debt

According to the Federal Reserve Bank of St. Louis, the average interest rate for subordinated debt was 6.29% in the first quarter of 2021. This is higher than the average interest rate for senior debt, which was 3.09% in the same period. The average interest rate for subordinated debt has been steadily declining since 2014, when it was over 9%.

In terms of volume, subordinated debt issuances have been on the rise in recent years. According to S&P Global Market Intelligence, subordinated debt issuance in the US reached a record high of $103.9 billion in 2020, up from $94.9 billion in 2019.

The majority of subordinated debt issuances in 2020 were from the financial sector, accounting for 50% of total issuances. The energy sector was the second-largest issuer, accounting for 15.5% of total issuances.

Conclusion

In conclusion, subordinated debt is an important tool for businesses and investors alike. While it carries more risk than other types of debt or equity financing, it can provide added flexibility and funding opportunities, as well as potentially higher returns for investors. However, it is important to carefully consider the creditworthiness of the business issuing the subordinated debt and be aware of the risks involved. Subordinated debt issuances have been on the rise in recent years, with the financial sector being the largest issuer. As with any investment, it is important to thoroughly research and understand the risks and potential rewards of subordinated debt before investing.

What is Subordinated Debt?

Subordinated Debt is a classification within the process of debt assessment concerning the financial analysis of debt hierarchy and urgency with regard to the respective itemization of debts accrued by an individual or entity; with regard to the respective classification implemented concerning specific types of debts, a debt classified as a ‘Subordinated Debt’ is a type of debt that is not considered priority with regard to the collective repayment of debts in possession of that individual or entity.

However, the methodology and ideology implemented with regard to the determination process of multiple debts – relating to their priority, as well as their implicit categorization an a Subordinated Debt – are subject to variation with regard to both the type of debt, as well as the value of that debt.

Subordinated Debt and Associated Terminology

Within the realm of debt management and financial assessment concerning the terms and conditions of Subordinated Debt – as well as debt itemization, the following legal and financial instruments are amongst the most commonly associated:

Non-Necessity Debt

Non-necessity debt is typically referred to as subordinated debt, which results from purchases undertaken through credit within the commercial marketplace, which varies with regard to the classification of prioritized debt due to the fact that items or services purchased may be eligible for the receipt of the classification of non-essential products or services.

Prioritized Debt

In contrast to Subordinated Debt, prioritized debt is classified as any nature of debt whose satisfaction and repayment is considered to maintain priority with regard to any and all debt in possession of an individual debtor; in many cases, prioritized debt will be classified as such – in contrast to classification as Subordinated Debt as a result of a variety of circumstances, which range from the valuation of the debt itself to the reliance of the debtor on the product or service associated with the debt in question.

Repossession

Repossession is defined as the legal process allowing the owner of a debt in default to reclaim the item in arrears; in certain cases, repossession may not require any notice or warning of the repossession effort in question – in other circumstances, the lending institution will not be permitted to reclaim property without expressing previous notice to the debtor.

Subordinated Debt Legality and Further Assistance

The standards and practices comprising statutory legislation and legal requirements associated with Subordinated Debt may range with regard to jurisdictional locale, applicable stipulations, and supplemental legality concerning the administration process of outstanding debt.

You are encouraged to familiarize yourself with any and all legislation and statutes associated with the jurisdiction within which you reside; although Federal legislation concerning Subordinated Debt may be uniform on a national basis, individual States of the Union will vary with regard to applicable debt legality.

In the event that you experience difficulty regarding the itemization and classification process concerning Subordinated Debt, you are encouraged to consult an attorney or legal counsel in order to provide you with the best assistance in your respective debt management.