Subordinated debt or debentures ranks lower than senior debt and higher than stocks. The term “subordinate” here refers to the priority and ranking of debt repayment in the case of the borrower’s liquidity. For issuers of debt, the senior debt gets the top priority, followed by different types of subordinated debentures, and the stocks at the lowest level.
They are often issued by large corporations in the form of bonds. These are unsecured bonds without collateral. The creditworthiness of the issuer decides the bond rating hence the interest rates on offer. Subordinated debentures are risker than senior debt such as secured bank loans.
What is Subordinated Debenture?
Subordinated debt is often issued in the form of bonds. It is ranked lower than senior debt in the case of default of the issuer. It carries more risk than secured loans. These are riskier and unsecured types of debts, hence are offered to large corporations.
The main risk that comes with a subordinated debenture is the risk of default of the issuer. In case, the issuer of subordinated debenture goes bankrupt, the subordinated debt will be repaid only after settling the senior debt. Since it carries more risk, the investors expect higher returns on it.
Investors in subordinated debentures are usually banks and large financial institutions. Corporations looking for cheaper finance can issue such debentures in the form of bonds. Since these are marketable securities, banks or corporations would willingly take the risk. These organizations need to adjust their investment portfolios as well as invest idle cash.
How Does Subordinated Debenture Work?
Companies can issue two types of debentures; subordinated and unsubordinated. A senior or unsubordinated debt is called the senior debt. Subordinated debt ranks lower than senior debt. It offers higher interest rates to investors as it is unsecured in nature.
Debentures are often issued without collateral. The creditworthiness of the issuer determines the credit rating of the debenture. Although large corporations issue unsecured and subordinated debentures, they carry higher risks.
They are issued for long-term investments. These are unsecured forms of debt without any collateral. Commonly, they are issued and borrowed by large corporations, banks, and financial institutions. For higher risks, the investors demand higher returns through high-interest rates.
They are noted on the liability section of the issuer. These are often issued for long-term, hence are listed under the long-term liability section of the balance sheet. It is listed below the secured or senior debt on the long-term liabilities section.
Subordinated Debenture – Bankruptcy Consideration
It is issued by large corporate entities with high credit ratings. Yet every organization faces the risk of default. In the case of a borrower’s default, the assets go into liquidation. The senior debt is settled on a priority basis before any other repayments. It is settled after the settlement of the senior debt.
In the case of bankruptcy, it is highly likely that lenders of subordinated debentures would not receive any repayment. Since, debentures are issued for large amounts, it makes them riskier debt instruments.
Issuers of subordinated debt must consider the solvency of the company. The lenders must also carefully evaluate the credit rating and solvency of the debenture issuer.
Subordinated and Senior Debt – Key Differences
A prime difference between a subordinated and senior debt is the priority rank at a bankruptcy event. If a business with both types of debentures goes into liquidation, the senior debt will get priority for repayment over subordinated debt. It has priority over the preferred and common stocks though.
Another key difference is the risk factor involved for the issuer and lender. The Senior debenture is considered less risky. It is a riskier instrument. Hence, lenders expect higher interest rates for investing in a risky instrument.
Advantages of Subordinated Debentures
Subordinated debentures can provide several benefits to issuers and lenders.
- Subordinated debentures are less costly than Equity and other unsecured bank loans for borrowers.
- Issuers of sub-debentures do not require any collateral usually and the credit rating decides the debenture classification.
- They also offer tax benefits to issuers.
- Debenture bonds are marketable securities.
- It is a flexible option for the long-term capital requirement of borrowers.
Disadvantages of Subordinated Debentures
Despite its usefulness and benefits, the subordinated debentures also offer some risks and disadvantages.
- Subordinated debentures are riskier investments for lenders than senior debts.
- Issuers need to offer higher interest rates to lenders.
- Lenders of subordinated debentures may not receive full repayment in the case of liquidation of the borrower.
- Debenture bonds are often issued without collateral.
Conclusion
Subordinated debentures are second-tier debt instruments after the senior debt. These are prioritized after the senior debt and before equity in the case of liquidation of the borrower. These debts offer higher interest rates as risk compensation for the lenders.