Subordinated Debt refers to a security or alternatively a loan which has a lower ranking to other debt securities and loans. This pertains to the claims on a corporation’s earnings or assets in the event of repayment default. Analysts also call this a subordinated loan or a junior security alternatively. When the borrower defaults on the loan or security in question, those creditors who extended the loan or investment and who are only holding a subordinated security will not receive any compensation until after all of the senior most debt holders have received payment in full. In principal this means that they will get little if anything at all back in the event of an actual default. Subordinated Debt proves to be the precise opposite of unsubordinated debt.
It helps to explain why such Subordinated Debt is always riskier for creditors or investors than comparable unsubordinated debts prove to be. Those firms which borrow on a subordinated debt basis generally turn out to be huge corporations and other businesses. Their size gives them the air of likelihood to repay a less sure loan or security.
As corporations take on more debt, they will typically issue at least two types of bonds as subordinated and unsubordinated debt. Should the huge corporation later default and then file for bankruptcy, it will be the responsibility of the bankruptcy court to decide on the priority of loan repayments according to seniority of the creditors. They will order the firm to pay off its debts using the proceeds from the sale of the corporate assets according to a certain order of repayment. Lower priority repayment debt turns out to be the unlucky Subordinated Debt. Greater priority debt will be the unsubordinated debt.
As the term implies, the liquidated assets through bankruptcy sale will first pay off the unsubordinated debts. If there is any cash remaining after these creditors are made whole first, then the unsubordinated debt holders will receive a portion of their funds back according to the schedule set out by the bankruptcy court. In the unlikely event that enough cash remains, the Subordinated Debt becomes completely repaid. It is more likely that the subordinated holders will get a payment in part or nothing whatsoever.
This explains why Subordinated Debt is so very risky in practice. Potential lenders or investors always have to be aware of the solvency prospects of the company in question as well as its total assets and other more senior debt obligations when they are considering investing in a given bond issue. Yet risky or not, these less senior bond holders still have seniority over all classes of stock holders in the company, even the preferred stock holders. Subordinated Debt bondholders will receive a greater rate of interest than the unsubordinated ones in order to make up for the possible default risk, which is very real.
Like with any debt obligations, such Subordinated Debt will appear on the principal company balance sheet. First the balance sheet will actually list out the firm’s current liabilities. Next comes the senior most debt, the unsubordinated issues, which will appear as longer term liabilities. Lastly, the subordinated issues appear as the longer term liabilities ranked according to their payment priority. As firms issue such subordinated bonds and then bring in the cash from the lender or investor, the cash account goes up, or alternatively the PPE property, plant, and equipment account. The firm’s accountants simultaneously record a liability for the exact amount.