Subordinated Debt
Quick Definition
Debt that ranks below senior debt in repayment priority, offering higher yields to compensate for the greater risk of loss in default.
Key Takeaways
- Ranks below senior debt in repayment priority
- Higher yields compensate for lower recovery rates (20–40%)
- Banks issue subordinated debt as regulatory Tier 2 capital
- Subordination can be structural or contractual
What Is Subordinated Debt?
Subordinated debt (also called junior debt) is any borrowing that ranks below senior debt in the capital structure, meaning subordinated creditors are repaid only after senior obligations are fully satisfied in a bankruptcy or liquidation. This lower priority translates into higher credit risk and correspondingly higher yields. Subordinated debt is commonly issued by banks as Tier 2 capital to meet regulatory requirements, and by corporations as part of leveraged financing structures. Recovery rates for subordinated debt historically average 20–40%, compared to 50–70% for senior debt. The subordination can be structural (the debt is at a holding company while assets are at subsidiaries) or contractual (written into the bond indenture).
Subordinated Debt Example
- 1A bank issues Tier 2 subordinated notes at 6.5% while its senior bonds yield 4.8%, reflecting the 170 bps subordination premium
- 2In a corporate bankruptcy with $500M in assets, $400M senior debt is repaid in full while $200M subordinated debt recovers only 50 cents on the dollar
Related Terms
Senior Debt
Debt that takes priority over other obligations in the event of default or bankruptcy, giving holders first claim on the issuer's assets.
Debenture
An unsecured bond backed only by the issuer's general creditworthiness and reputation, without specific collateral pledged.
Default Risk
The probability that a bond issuer will fail to make scheduled interest or principal payments, potentially resulting in partial or total loss for bondholders.
Bond Indenture
The legal contract between a bond issuer and bondholders that specifies the bond's terms, covenants, and the rights and obligations of each party.
Bond
A fixed-income debt security where investors loan money to an issuer in exchange for regular interest payments and return of principal at maturity.
Treasury Bond (T-Bond)
A long-term U.S. government debt security with a maturity of 20 or 30 years, paying semiannual coupon interest.
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