Definition

Subordinated debt is debt that, in case of bankruptcy, only gives a subordinated claim to the assets of a company. In practice, this means you are third in line to receive anything in case of a bankruptcy. First, creditors that receive a preferential treatment by law get their share. Who these creditors are depends of course on the specifics of the law in your country, but usually, these are the government, the bankruptcy trustee, and sometimes the employees. Then, if anything is left, the holders of senior debt receive their slice. If at this point anything is left, the holders of subordinated debt receive a slice. If then anything is left, the shareholders receive money - but in that case, the company wouldn't really be bankrupt, as it could pay its debts.

Use of subordinated debt

While the difference between senior and subordinated debt seems a technicality, it actually is not. You see, in practice, holders of senior debt can expect to see quite a bit back in case of a bankruptcy, often as much as 30 to 50%. This automatically means that subordinated debt holders can expect to get nothing back - just like the shareholders! However, shareholders benefit in the growth of the company. Subordinated debtholders do not; they have the risk of the shareholder, but the benefits of a bondholder.

In order to compensate the holder of subordinated debt, the interest on it is higher. This can be as much as a few percent, which is great, because as long as everything goes fine, you reap a nice reward.

Furthermore,subordinated debt is not necessarily just as risky as shares. You see, a company can do a rights issue to raise more equity. This means that the shareholders are "forced" to pay cash to keep their share in the company. People holding subordinated debt don't have this risk. In practice, this is quite a substantial difference: more than one company has pulled itself from the brink by essentially bleeding its shareholders.

Investing in subordinated debt

It is possible to invest in subordinated debt. As seen from the discussion above, the risk profile is somewhere between shares and a bond. What is perhaps unpleasant here is that the risk profile tends to be like that of a bond when everything goes fine, but is more like shares when it doesn't.

It is very important in practice to have a thorough understanding of what one is buying when one invests in subordinated debt. Each piece of subordinated debt is a unique product and needs to be analyzed as such. Nuances of bankruptcy law become important, as does the entire structure of the company. Some of these bonds only pay interest if the company pays a dividend or makes a profit. Some are perpetual, some are not. For shares, there is a liquid, efficient markets, so we "know" a fair value. For subordinated debt, this is not always the case. Some are not even traded.

Some banks offer subordinated time deposits. This is perhaps the easiest way in which a normal private investor can own subordinated debt. Note that this combines the risks of a time deposit with the risks of subordinated debt: you are stock with a default risk for quite a while, with no realistic way of hedging it. This is definitely not your run-of-the-mill savings account.

Conclusion

Subordinated debt is debt that is paid back last in case of a bankruptcy, just before the shareholders get paid. As such, its risk is between that of normal debt and shares. The actual risks are product-specific, and one should investigate thoroughly what the risks are before investing in these products.

Standard disclaimer: This is meant as general background information, not as investment or trading advice. Don't take financial advice from random anonymous strangers on the Internet.

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