# Subordinated Debt: What It Is, How It Works, Risks

## What Is Subordinated Debt?

Subordinated debt, often called a subordinated debenture, represents an unsecured loan or bond that [ranks below senior loans](https://www.investopedia.com/terms/s/subordination-agreement.asp) or securities when it comes to claims on assets or earnings. Known as junior securities, subordinated debt poses a higher risk because, in borrower default situations, it is only paid after senior debts are fully settled.

However, subordinated debt holders are compensated for this risk with higher interest rates compared to senior debt. This structure makes it crucial for potential lenders to diligently assess a corporation's solvency and total debt obligations before committing. Subordinated debt offers insight into corporate financial health and operational discipline, especially in industries like banking, where the tax-deductible nature of interest makes such debt attractive.

### Key Takeaways

*   Subordinated debt is a type of loan or bond that is ranked below other loans regarding claims on assets in a default situation, leading to higher risks but offering higher interest rates as compensation.
*   In bankruptcy or liquidation, senior debt is paid first, and only after it is fully satisfied, any remaining funds are used to pay subordinated debt, which might result in partial or no repayment.
*   Borrowers like corporations issue subordinated debt to utilize it for risk management and regulatory capital requirements, especially in the banking industry, where it is tax-deductible.
*   Subordinated and senior debts differ mostly by their claim priority. While subordinated debt is riskier, it is still repaid before equity, unlike senior debt, which features lower risk and interest rates.
*   Asset-backed securities can include subordinated components, such as mezzanine debt, which are designed to spread investment risk across different investor profiles through tranches.

![Subordinated Debt](https://www.investopedia.com/thmb/3p5pVSY-OkUkZqwgI-StDvWENPs=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Subordinated_Debt_Final-9aa6c6855b944c68bbc92fafaf12bd9b.png)

*— Investopedia / Candra Huff*

## How Subordinated Debt Differs from Other Debt Types

Subordinated debt is riskier than unsubordinated debt. Subordinated debt is a loan paid after other corporate debts if a borrower defaults.

Borrowers of subordinated debt are usually larger corporations or other business entities. Subordinated debt is the exact opposite of unsubordinated debt in that senior debt is [prioritized higher](https://www.investopedia.com/ask/answers/061615/what-difference-between-subordinated-debt-and-senior-debt.asp) in bankruptcy or default situations.

## Repayment Process for Subordinated Debt

When a corporation takes out debt, it normally issues two or more [bond](https://www.investopedia.com/terms/b/bond.asp) types that are either unsubordinated debt or subordinated debt. If the company defaults and files for bankruptcy, a bankruptcy court will prioritize loan repayments and require that the company repay its outstanding loans with its assets. The debt that is considered lower in priority is the subordinated debt. The higher priority debt is considered unsubordinated debt.

Liquidated assets first pay unsubordinated debt; any remaining cash goes to subordinated debt. Any cash in excess of the unsubordinated debt will then be allocated to the subordinated debt. Subordinated debt holders are fully repaid if there's enough cash; they might receive partial or no payment otherwise.

Potential lenders should consider a company's solvency, other debts, and assets before investing in subordinated debt due to its risk. Despite its risk, subordinated debt is paid before equity holders. Bondholders of subordinated debt are also able to realize a higher rate of interest to compensate for the potential risk of default.

While subordinated debt is issued by a variety of organizations, its use in the banking industry has received special attention. Such debt is attractive for banks because interest payments are tax-deductible. A 1999 study by the Federal Reserve recommended that banks issue subordinated debt to self-discipline their risk levels. The study's authors argued that issuance of debt by banks would require profiling of risk levels, which, in turn, would provide a window into a bank's finances and operations during a time of significant change after a repeal of the Glass-Steagall Act. In some instances, subordinated debt is being used by mutual savings banks to buffer up their balance to meet regulatory requirements for [Tier 2 capital](https://www.investopedia.com/terms/t/tier2capital.asp).

## Corporate Reporting of Subordinated Debt

Subordinated debt is a liability on a company's balance sheet, like all debts. Current liabilities are listed first on the balance sheet. Senior or unsubordinated debt is listed as a long-term liability. Finally, subordinated debt is listed on the balance sheet as a long-term liability in order of payment priority, beneath any unsubordinated debt. When a company issues subordinated debt and receives cash from a lender, its cash account, or its [property, plant, and equipment (PPE)](https://www.investopedia.com/terms/p/ppe.asp) account, increases, and a liability is recorded for the same amount.

## Comparing Subordinated Debt and Senior Debt

The main difference between subordinated and senior debt is the repayment priority in bankruptcy or liquidation. If a company has both subordinated debt and senior debt and has to file for bankruptcy or face liquidation, the senior debt is paid back before the subordinated debt. Once the senior debt is completely paid back, the company then repays the subordinated debt.

Senior debt has the highest priority and lowest risk, typically carrying lower interest rates. Meanwhile, subordinated debt carries higher interest rates given its lower priority during payback.

Senior debt is generally funded by banks. The banks take the lower-risk senior status in the repayment order because they can generally afford to accept a lower rate given their low-cost source of funding from deposit and savings accounts. In addition, regulators advocate for banks to maintain a lower-risk loan portfolio.

Subordinated debt is any debt that falls under, or behind, senior debt. However, subordinated debt does have priority over preferred and common equity. Examples of subordinated debt include [mezzanine debt](https://www.investopedia.com/terms/m/mezzaninedebt.asp), which is debt that also includes an investment. Additionally, asset-backed securities generally have a subordinated feature, where some tranches are considered subordinate to senior tranches. Asset-backed securities are financial securities collateralized by a pool of assets, including loans, leases, credit card debt, royalties, or receivables. Tranches are portions of debt or securities that have been designed to divide risk or group characteristics so that they can be marketable to different investors.

> **Article Sources**
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> 1.  Internal Revenue Service. "[Publication 535: Business Expenses 2022](https://www.irs.gov/pub/irs-prior/p535--2022.pdf)." Pages 13-17.
>     
> 2.  Federal Reserve System. "[Using Subordinated Debt as an Instrument of Market Discipline](https://www.federalreserve.gov/pubs/staffstudies/1990-99/ss172.pdf)," Pages 1-5.
>     
> 3.  Federal Deposit Insurance Corporation. "[Capital Section 2.1](https://www.fdic.gov/regulations/safety/manual/section2-1.pdf)," Page 2.1-3.