Subordinated debt
Encyclopedia
In finance
, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts should a company fall into receivership
or bankruptcy
.
Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal 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.
Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation
during bankruptcy
, below the liquidator
, government tax authorities and senior debt holders in the hierarchy of creditors. Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the same asset.
Subordinated loans typically have a higher rate of return
than senior debt due to the increased inherent risk. Accordingly, major shareholder
s and parent companies are most likely to provide subordinated loans, as an outside party providing such a loan would normally want compensation for the extra risk. Subordinated bonds usually have a lower credit rating than senior bonds.
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 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). 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 an incentive for bank management to act prudently, thus helping to offset the moral hazard
that can otherwise exist, especially if 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 tranches. The senior tranches get paid back first, the subordinated tranches later. Finally, mezzanine debt
is another example of subordinated debt.
Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as asset-backed securities
, collateralized mortgage obligations or collateralized debt obligation
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
to create so called monthly income preferred stock
, a hybrid security
paying dividends for the lender and funded as interest expense by the issuer.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts should a company fall into receivership
Receivership
In law, receivership is the situation in which an institution or enterprise is being held by a receiver, a person "placed in the custodial responsibility for the property of others, including tangible and intangible assets and rights." The receivership remedy is an equitable remedy that emerged in...
or bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
.
Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal 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.
Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
during bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, below the liquidator
Liquidator (law)
In law, a liquidator is the officer appointed when a company goes into winding-up or liquidation who has responsibility for collecting in all of the assets of the company and settling all claims against the company before putting the company into dissolution....
, government tax authorities and senior debt holders in the hierarchy of creditors. Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the same asset.
Subordinated loans typically have a higher rate of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
than senior debt due to the increased inherent risk. Accordingly, major shareholder
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
s and parent companies are most likely to provide subordinated loans, as an outside party providing such a loan would normally want compensation for the extra risk. Subordinated bonds usually have a lower credit rating than senior bonds.
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
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
-sensitive, because subordinated debt holders have claims on bank assets 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
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...
, 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). 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 an incentive for bank management to act prudently, thus helping to offset the moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
that can otherwise exist, especially if 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 tranches. The senior tranches get paid back first, the subordinated tranches later. Finally, mezzanine debt
Mezzanine capital
Mezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares...
is another example of subordinated debt.
Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as asset-backed securities
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
, collateralized mortgage obligations or collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
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
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
to create so called monthly income preferred stock
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...
, a hybrid security
Hybrid security
Hybrid securities are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity.Hybrid securities pay a predictable rate of return or dividend until a certain date, at which point the holder has a number of options including converting the...
paying dividends for the lender and funded as interest expense by the issuer.
See also
- Tier 2 capitalTier 2 capitalTier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
- Basel IIBasel IIBasel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...
- Bank conditionBank conditionBank condition is a random variable used to represent the probability of failure of a bank. The true probability of failure is unknown to depositors....
- Banking regulation
- CAMELS rating
- Perpetual subordinated debtPerpetual subordinated debtPerpetual subordinated debt is debt with no maturity date for the return of principal, never needs to be redeemed by the issuer, and thus pay coupon interest continually until bought back...
External links
- http://www.anz.com/edna/dictionary.asp?action=content&content=subordinated_loan