Subordinated Bond
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In
finance Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...
, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts if a company falls into
liquidation Liquidation is the process in accounting by which a Company (law), company is brought to an end. The assets and property of the business are redistributed. When a firm has been liquidated, it is sometimes referred to as :wikt:wind up#Noun, w ...
or
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...
. Such debt is referred to as 'subordinate', because the debt providers (the lenders) have subordinate status in relationship to the normal debt. Subordinated debt has a lower priority than other bonds of the issuer in case of
liquidation Liquidation is the process in accounting by which a Company (law), company is brought to an end. The assets and property of the business are redistributed. When a firm has been liquidated, it is sometimes referred to as :wikt:wind up#Noun, w ...
during
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...
, and ranks below: the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors. Debt instruments with the lowest seniority are known as subordinated debt instruments. Because subordinated debts are only repayable after other debts have been paid, they are riskier for the lender of the money. The debts may be secured or unsecured. Subordinated loans typically have a lower
credit rating A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government). It is the practice of predicting or forecasting the ability of a supposed debtor to pay back the debt or default. The ...
, and, therefore, a higher yield than senior debt. A typical example for this would be when a promoter of a company invests money in the form of debt rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves), the promoter would be paid just before stockholders — assuming there are assets to distribute after all other liabilities and debts have been paid. While subordinated debt may be issued in a public offering, major
shareholder A shareholder (in the United States often referred to as stockholder) of corporate stock refers to an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the ...
s and parent companies are more frequent buyers of subordinated loans. These entities may prefer to inject capital in the form of debt, but, due to the close relationship to the issuing company, they may be more willing to accept a lower rate of return on subordinated debt than general investors would.


Examples

A particularly important example of subordinated bonds can be found in bonds issued by banks. Before the
2008 financial crisis The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...
, subordinated debt was issued periodically by most large banking corporations in the U.S. Subsequently the
private credit Private credit is an asset defined by non-bank lending where the debt is not issued or traded on the public markets. "Private credit" can also be referred to as " direct lending" or " private lending". It is a subset of "alternative credit". E ...
middle-market increased debt issuance. Subordinated debt can be expected to be especially
risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environ ...
-sensitive because subordinated debt holders have claims on bank assets only after senior debtholders and they lack the upside gain enjoyed by shareholders. This status of subordinated debt makes it perfect for experimenting with the significance of
market discipline Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy. This means, in order to meet economic necessity, buyers must avoi ...
, via the signaling effect of secondary market prices of subordinated debt (and, where relevant, the issue price of these bonds initially in the primary markets). From the perspective of policy-makers and regulators, the potential benefit from having banks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the "supervision" of the financial condition of the banks. This, hopefully, creates both an early-warning system, like the so-called "canary in the mine", and, also hopefully, an incentive for bank management to act prudently, thus helping to offset the
moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs associated with that risk, should things go wrong. For example, when a corporation i ...
that can otherwise exist, especially in a circumstance where banks have limited equity and deposits are insured. This role of subordinated debt has attracted increasing attention from policy analysts in recent years. For a second example of subordinated debt, consider asset-backed securities. These are often issued in
tranche In structured finance, a tranche () is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see indent ...
s. The senior tranches get paid back first; the subordinated tranches later. A third example is
mezzanine debt Mezzanine capital is a type of financing that sits between senior debt and equity in a company's capital structure. It is typically used to fund growth, acquisitions, or buyouts. Technically, mezzanine capital can be either a debt or equity ins ...
.


Use

Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as in the issue of asset-backed securities,
collateralized mortgage obligation A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor need ...
s or
collateralized debt obligation A collateralized debt obligation (CDO) is a type of structured finance, structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing Mortgage-backed se ...
s. Corporate issuers tend to prefer not to issue subordinated bonds because of the higher interest rate required to compensate for the higher risk, but may be forced to do so if indentures on earlier issues mandate their status as senior bonds. Also, subordinated debt may be combined with
preferred stock Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt ins ...
to create so-called
monthly income preferred stock Monthly income preferred stock or MIPS is a hybrid security created by Eli Jacobson, a Sullivan & Cromwell tax partner, and introduced to the market by Goldman Sachs in 1993. In essence, MIPS is a combination of deeply subordinated debt and preferr ...
, a
hybrid security Hybrid securities are a broad group of securities that combine the characteristics of the two broader groups of securities, debt and equity. Hybrid securities pay a predictable (either fixed or floating) rate of return or dividend until a cert ...
paying dividends for the lender and funded as interest expense by the issuer.


See also

*
Tier 2 capital Tier 2 capital, or supplementary capital, includes a number of important and legitimate constituents of a bank's capital requirement.By definition of Bank for International Settlements. These forms of banking capital were largely standardized in the ...
*
Basel II Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III. The Basel II Accord was publ ...
* Bank condition *
Banking regulation Banking regulation and supervision refers to a form of financial regulation which subjects banks to certain requirements, restrictions and guidelines, enforced by a financial regulatory authority generally referred to as banking supervisor, with ...
* CAMELS rating *
Perpetual subordinated debt Perpetual subordinated debt is subordinated debt in the form of a bond with no maturity date for the return of principal. Such a perpetual bond means it never needs to be redeemed by the issuer, and thus pay coupon interest continually until bou ...
*
Structural subordination In corporate finance, structural subordination is the concept that a lender to a company will not have access to the assets of the company's subsidiary until after all of the subsidiary's creditors have been paid and the remaining assets have been d ...


References


External links


Federal Register

Freddie Mac

FINRA
{{DEFAULTSORT:Subordinated Debt Credit Bonds (finance) Debt