Subordinated Debt – Definition

Cite this article as:"Subordinated Debt – Definition," in The Business Professor, updated May 6, 2019, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/subordinated-debt-definition/.

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Subordinated Debt Definition

Subordinated Debt or subordinated loan is a loan or security which is prioritized lower than other loans or securities on the occasions of bankruptcy or liquidation. That means if the borrower company default or faces insolvency, the subordinated debt holders will be paid after senior debt holders are repaid fully. The creditors owning a subordinated debt can claim the asset of the borrower firm only after the claims of other debt holders are fully satisfied. This is also known as junior security or junior debt.

A Little More on What is Subordinated Debt

Subordinated debts can both be secured or unsecured. It is riskier than other debts as on an occasion of liquidation, the subordinated debt holder is paid last. They are paid after the full repayment of all other corporate debts and loans.

Generally, the big corporations and businesses are the borrower of a subordinated loan. The promoters of a business may invest their money in the form of a subordinated debt. In that case, if the company liquidate, the promoter will be paid just before the stockholders, if there’s enough asset left after satisfying the claim of the senior debt holders.

When a company files for its bankruptcy the court directs the company to prioritize the loan repayment. The company needs to repay all the loans with its assets. The unsubordinated debt holders/bondholders are paid first. After fully satisfying their demand if there are still assets left, the subordinated debt holders are paid. The subordinated bondholders may be paid partially or fully depending on the amount of assets left.

The large banking corporations often issue subordinated bonds, these bondholders are paid after all other debts are repaid. The interest payments are tax deductible; thus, the banks find it attractive.

While investing carefully an unsubordinated bond may actually be profitable for the investor as it earns a higher interest rate. The potential risk attached to a subordinated bond is balanced by this high rate of interest. The subordinated debt holders are paid just before the equity holders. However, an investor should thoroughly review the issuing company’s other debt obligations and total asset before investing in an unsubordinated bond to avoid any loss.

The corporations generally do not prefer to issue the subordinated bonds because of their high-interest rate. However, they may have to issue subordinated bonds if indentures of earlier issues specify those as senior bonds.

Subordinated debt is recorded as a long-term liability on the balance sheet of the company. On the balance sheet, the current liabilities are recorded on the top. After that, the unsubordinated debt is listed as a long-term liability. The subordinated debt is listed after this.

References for Subordinated Debt

Academic Research on Subordinated Debt

Market discipline and bank subordinated debt: Note, Gorton, G., & Santomero, A. M. (1990). Journal of money, credit and Banking, 22(1), 119-128. This note argues that there is a serious flaw in the inquiry method used by the existing literature to investigate whether the market prices of liabilities respond to individual bank risk-taking activity. The note says the existing inquiry method fails to use a theoretical model of bank instrument valuation in their investigation about the existence of market discipline. This paper uses a pricing model borrowed from the options pricing literature to examine the yield spread on bank liabilities.

Testing for market discipline in the European banking industry: evidence from subordinated debt issues, Sironi, A. (2003). Journal of Money, Credit and Banking, 443-472. This paper investigates whether private investors are able to discriminate between the risk taken by banks. It uses data of a sample of subordinated notes and debentures (SND) spreads issued during 1991-2000 by the European Banks to test their risk sensitivity. The result concludes that the SND investors get affected by the bank risk when it is not issued by a public sector bank.

Subordinated debt and bank capital reform, Evanoff, D. D., & Wall, L. D. (2000). This article evaluates the purpose and potential of the proposals that recommend increasing the role of subordinated debt in the bank capital requirement for encouraging prudent risk management. A regulatory reform proposal that incorporates some of the most desirable characteristics of subordinated debt is also presented in the paper.

The information content of bank exam ratings and subordinated debt prices, DeYoung, R., Flannery, M. J., Lang, W. W., & Sorescu, S. M. (2001). Journal of Money, Credit and Banking, 900-925. This paper uses a new research methodology to find out whether the supervisory examinations of large commercial banking firms are able to provide any extra information that is not already reflected in the market prices. It uses data on bank examination ratings and the subordinated debt risk spreads of their parent holding companies in this research. The study concludes that the bank exams produce new useful information which is not immediately reflected by the debenture prices.

Market discipline of bank risk: Evidence from subordinated debt contracts, Goyal, V. K. (2005). Journal of Financial Intermediation, 14(3), 318-350. This paper aims to find out whether the bank debt holders discipline excessive risk-taking. It examines the impact of a bank’s incentives to take risks on the offering yield spreads and restrictive covenants. The study finds the likelihood of restrictive covenants in bank debt contracts is considerably affected by bank charter values. A bank’s risk-taking incentives are determined by this charter values. The paper identifies this effect was highest during the time when the moral hazard problems of the US banking sector was increased in the 1980s. The paper concludes that writing restrictive covenants in bank debt is an effective method for market investors to discipline bank risk taking.

Subordinated debt, market discipline, and banks’ risk taking, Blum, J. M. (2002). Journal of Banking & Finance, 26(7), 1427-1441. This paper attempts to identify how the risk-taking incentives of banks get affected by the subordinated debt. It shows when the banks are able to commit to a certain level of risk credibly, the subordinated debt reduces the risk level but when it cannot commit, the risk is increased by the subordinated debt. The reason for this occurrence is explained in the paper.

Using subordinated debt to monitor bank holding companies: Is it feasible?, Hancock, D., & Kwast, M. L. (2001). Journal of Financial Services Research, 20(2-3), 147-187. This paper analyzes whether a subordinated debt and other market data based supervisory system can be implemented successfully for bank holding companies. The results suggest subordinated debt spreads can be used in supervisory monitoring; however, the spreads need to be interpreted with careful judgment in order to implement it successfully. The paper provides guidance on how to use these spreads and identifies difficulties with the available data sources.

A plan for reducing future deposit insurance losses: Puttable subordinated debt, Wall, L. D. (1989). Economic Review, 74(4), 2-17. This paper proposes to use subordinated debt for building up a supervisory monitoring system for banking organizations. It suggests the subordinated debt can be used to force the closure of a banking organization which is in danger of bankruptcy. It describes the method of using the subordinated debt for the above purpose and suggests that would create a market discipline which is similar to the discipline provided by deposit runs but without developing the liquidity risk of a run.

Market discipline and subordinated debt: A review of some salient issues, Bliss, R. R. (2001). Economic Perspectives-Federal Reserve Bank of Chicago, 25(1), 24-45. This article explores the frictions that give birth to the necessity of implementing a supervisory monitoring system for banking organizations. Then it analyzes the systems that are evolved by the market to deal with these frictions. It examines the rationales and assumptions behind the proposals that advocate for using subordinated debt for monitoring the banks. It concludes a regulatory intervention based on subordinated debt spreads is not straight forward. Rather, it suggests, using all available information including equity returns and debt yields, will be more helpful for this purpose.

Analysis of proposals for a minimum subordinated debt requirement, Lang, W. W., & Robertson, D. D. (2002). Journal of Economics and Business, 54(1), 115-136. This paper analyzes the rationale behind the proposals that advocate for using subordinated debt information for monitoring the banks. The advantages and disadvantages of this proposal are analyzed in this paper. The results suggest risk sensitivity of bank costs at most large banks will only modestly increase by the implementation of this proposal. However, the paper argues using subordinated debt as a market-based trigger for regulatory action will yield significant benefits.

Subordinated debt and the quality of market discipline in banking, Levonian, M. (2001). FRB San Francisco. This paper compares the utility of subordinated debt with that of common equity as a source of market discipline in banking. It concludes that using the subordinated debt as a form of bank capital or as a source of market discipline instead of using equity has few advantages but in some important regards subordinated debt is inferior to the equity.

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