Subordinated Debt

How Does Subordinated Debt Work?

The term “subordinated debt”, often used interchangeably with junior debt, is used to categorize debt securities with lower priority relative to the senior debt tranches.

The following list ranks the capital structure components in order of descending priority.

1. Senior Debt (Term Loans, Revolver)
2. Subordinated Debt (High Yield Bonds, PIK Debt, Mezzanine Financing)
3. Equity (Preferred Equity, Common Stock)

If a borrower were to hypothetically default on its debt obligations and file for bankruptcy protection, the claims held by senior debt lenders would be prioritized by the Bankruptcy Court.

Because their claims hold seniority and their chance of recovering their initial capital contribution is the highest in a bankruptcy or liquidation scenario (i.e. lower risk), senior debt is priced at the lowest interest rate (and is considered the “cheapest” source of financing).

In contrast, subordinated debt does not possess the same type of protection and is less likely to recoup its initial investment.

Given the higher risk tied to subordinated debt, the pricing – i.e. the interest rate – is set at a higher level than that of senior debt to compensate the subordinate lender for the additional risk.

Subordinated Debt vs. Senior Debt: What is the Difference?

In the event of default, subordinated debt claims are paid out once senior debt holders have first been repaid in full, i.e. all debt obligations per the loan agreement have been satisfied.

To reiterate from earlier, subordinated debt is riskier than senior debt because of its lower placement in the priority of claims (and thus, these sorts of securities carry higher interest rates than senior debt).

• Unsecured Debt: Unlike senior debt, subordinated debt is rarely secured, meaning that the lending agreement did not require the borrower to pledge collateral as part of the financing agreement. In the event of default, senior debt lenders are in a far more favorable position given their typical liens on the borrower’s asset base.
• Early Repayment Fees: Senior debt lenders rarely penalize a borrower for early repayment of the debt, even if it results in a lower yield (i.e. the amortization of principal causes future interest payments to decline). Senior lenders, such as traditional commercial banks, are more risk-averse than subordinated lenders. That said, subordinated debt lenders are more likely to charge fees for borrowers that repay debt ahead of schedule, in an effort to mitigate the loss in return for the lower interest expense (or the lender might prohibit early repayment for a set number of years or the entire borrowing term).
• Fixed Interest Rate: Subordinated debt securities such as high-yield bonds (HYBs) are usually priced at a fixed interest rate. The pricing is structured as fixed to ensure the lender receives an expected yield irrespective of the prevailing economic conditions, whereas the floating interest rate would fluctuate based on an underlying rate benchmark (e.g. SOFR, LIBOR).

What are Examples of Subordinated Debt?

Companies seeking debt financing for the first time normally opt for traditional bank loans.

But once the maximum amount of senior debt has been raised – i.e. there is an upper limit to how much senior lenders are comfortable lending – companies still in need of additional financing must obtain the rest of the capital from riskier lenders.

Below are some common examples of subordinated debt instruments:

• 2nd Lien Subordinated Notes
• High Yield Bonds (HYBs)
• Paid-in-Kind (PIK) Notes
• Convertible Debt
• Mezzanine Financing, i.e. Hybrid Securities

Subordinated debt instruments sit right in between senior debt and equity in the overall capital stack, so in a liquidation, subordinated debt claims are only paid once senior debt claims are repaid in full but before any equity claims.

Compared to equity holders – both preferred stock and common shareholders – subordinated debt is less risky and higher in terms of priority. However, they do not have the same type of unlimited upside as equity.