What is Subordinated Debt?

//What is Subordinated Debt?
What is Subordinated Debt? 2017-10-10T08:04:39+00:00

Definition: The subordinated debt, or junior debt, represents the obligations that rank lower than all other loans and securities with respect to the claim on a firm’s assets. Therefore, if the borrower defaults, the creditors of subordinated debt will be compensated after all other debt holders are paid in full.

What Does Subordinated Debt Mean?

What is the definition of subordinated debt? The junior debt is riskier than any other type of debt, and the risk is conversely related to its ranking. That means that the risk increases as the debt ranks lower and decreases as the debt ranks higher.

Therefore, the creditors should assess the borrower’ solvency to properly evaluate the risk associated with the debt on demand and consider if they should approve the loan or not. As a rule of thumb, in the case that a borrower defaults, the junior debt is paid after all corporate debts and loans are compensated in full.

Let’s look at an example.

Example

Company ABC is a large corporation that operates in the pharmaceutical industry. The company issues two types of bonds with different maturity and different face value. Bond A has a face value of $5,000, and it matures in 10 years, and Bond B has a face value of $10,000, and it matures in 20 years.

In the year 2, the company faces extreme financial hardships, and it has to go out of business. Therefore, it has to liquidate its assets to pay off its total debt. The court determines that the money that the company owes to the bondholders of Bond B is the company’s primary debt. So, these bondholders will be compensated first. The money owed to the bondholders of Bond A is the company’s junior debt, and, therefore, it will be paid last.

In fact, the importance of junior debt increases when the debtor owes more than one creditor and the total value of assets is insufficient to compensate for all the liabilities at the time of default.

Summary Definition

Define Subordinated Debts: Subordinated debt means the lower ranking loans in bankruptcy hearings.