Subordinated debt

In finance, 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 or bankruptcy.

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 during bankruptcy, 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 more risky for the lender of the money. The debts may be secured or unsecured. Subordinated loans typically have a lower credit rating, 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 shareholders 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.

A particularly important example of subordinated bonds can be found in bonds issued by banks. Subordinated debt is issued periodically by most large banking corporations in the U.S. Subordinated debt can be expected to be especially risk-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, via the signalling effect of secondary market prices of subordinated debt (and, where relevant, the issue price of these bonds initially in the primary markets).

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