Definition of Subordinated Debt
Subordinated debt, also known as a subordinated bond, debenture or junior debt, is a type of debt that is paid back after other (or primary) debts in the event a company falls into receivership, is closed or for any other reason is forced to pay back all its debts at once.
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Why Is It Called Subordinated?
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Subordinated debt is so-named because lenders have a secondary payback priority to normal or priority debt. For example, if a company owes money to another company in the form of debt equity, that debt is paid before stockholders are paid if the first company dissolves.
Subordinated debt is lower in priority than other primary bonds of the issuer during cases of liquidation for bankruptcy, as well as below the liquidator (who is paid for selling the assets), government tax authorities and primary debt or bond holders. Because of this, the risk assessment for subordinated debt is higher.
Why Would You Accept Subordinated Debt?
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Because the risk assessment for subordinated debt is higher than that of primary debt, subordinated loans and bonds generally pay more to make up for the risk and to make it more attractive to the lender. Preexisting shareholders and other business units under the same overall organization are more likely to lend subordinated debt, as they are more willing to take on the risk than are new lenders.
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Examples of Subordinated Debt
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A simple example of subordinated debt is certain bonds issued by banks as a tool for examining the market. A bank will issue subordinated bonds, which it views as risk sensitive (as do the lenders). While the bank has to pay out more money due to the higher rate of return, it can view how the market is working for a given period in time by observing primary (issuing) and secondary (trading between buyers) prices.
How Is Subordinated Debt Issued?
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The primary way subordinated bonds are issued, apart from bank observation methods, is as part of securitization of debt. This includes items such as asset-backed securities, collateralized debt obligations and other collateralized and asset-backed debt. Most corporations avoid issuing subordinated bonds to avoid the higher payout required, but they may be forced to as indentures on earlier issues raise them to senior bonds.
Tier 2 Capital
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Subordinated debt is a type of capital known as tier 2 capital, which is so-named because it is a measure of a bank's financial strength using the second-most reliable form of capital. These tiers were set in the Basel I accord, an international accord of banking standards. This is implemented in most countries around the world, including nearly all nations in which significant financial transactions take place.
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References
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