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In finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts if a company falls into liquidation or bankruptcy.
Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.
Liquidation is the process in accounting by which a company is brought to an end in the United Kingdom, Republic of Ireland and United States. The assets and property of the company are redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation. The process of liquidation also arises when customs, an authority or agency in a country responsible for collecting and safeguarding customs duties, determines the final computation or ascertainment of the duties or drawback accruing on an entry.
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor.
Such debt is referred to as 'subordinate', because the debt providers (the lenders) have subordinate status in relationship to the normal debt.
Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy, and ranks below: the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors. Debt instruments with the lowest seniority are known as subordinated debt instruments.
In law, a liquidator is the officer appointed when a company goes into winding-up or liquidation who has responsibility for collecting in all of the assets under such circumstances of the company and settling all claims against the company before putting the company into dissolution.
Because subordinated debts are only repayable after other debts have been paid, they are more risky for the lender of the money. The debts may be secured or unsecured. Subordinated loans typically have a lower credit rating, and, therefore, a higher yield than senior debt.
A credit rating is an evaluation of the credit risk of a prospective debtor, predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting. The credit rating represents an evaluation of a credit rating agency of the qualitative and quantitative information for the prospective debtor, including information provided by the prospective debtor and other non-public information obtained by the credit rating agency's analysts.
In finance, the yield on a security is the amount of cash that returns to the owners of the security, in the form of interest or dividends received from it. Normally, it does not include the price variations, distinguishing it from the total return. Yield applies to various stated rates of return on stocks, fixed income instruments, and some other investment type insurance products.
A typical example for this would be when a promoter of a company invests money in the form of debt rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves), the promoter would be paid just before stockholders — assuming there are assets to distribute after all other liabilities and debts have been paid.
While subordinated debt may be issued in a public offering, major shareholders and parent companies are more frequent buyers of subordinated loans. These entities may prefer to inject capital in the form of debt, but, due to the close relationship to the issuing company, they may be more willing to accept a lower rate of return on subordinated debt than general investors would.
A shareholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders may be referred to as members of a corporation. Legally, a person is not a shareholder in a corporation until their name and other details are entered in the corporation's register of shareholders or members.
A parent company is a company that owns enough voting stock in another firm to control management and operation by influencing or electing its board of directors. The company is deemed a subsidiary of the parent company.
A particularly important example of subordinated bonds can be found in bonds issued by banks. Subordinated debt is issued periodically by most large banking corporations in the U.S. Subordinated debt can be expected to be especially risk-sensitive because subordinated debt holders have claims on bank assets only after senior debtholders and they lack the upside gain enjoyed by shareholders.
Risk is the possibility of losing something of value. Values can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen. Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is an aspect of action taken in spite of uncertainty.
This status of subordinated debt makes it perfect for experimenting with the significance of market discipline, via the signalling effect of secondary market prices of subordinated debt (and, where relevant, the issue price of these bonds initially in the primary markets).
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy. This means, in order to meet economic necessity, buyers must avoid prices that will drive them into bankruptcy and sellers must find prices that will generate revenue.
From the perspective of policy-makers and regulators, the potential benefit from having banks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the "supervision" of the financial condition of the banks. This, hopefully, creates both an early-warning system, like the so-called "canary in the mine", and, also hopefully, an incentive for bank management to act prudently, thus helping to offset the moral hazard that can otherwise exist, especially in a circumstance where banks have limited equity and deposits are insured. This role of subordinated debt has attracted increasing attention from policy analysts in recent years.
For a second example of subordinated debt, consider asset-backed securities. These are often issued in tranches. The senior tranches get paid back first; the subordinated tranches later.
A third example is mezzanine debt.
Subordinated bonds are regularly issued (as mentioned earlier) as part of the securitization of debt, such as in the issue of asset-backed securities, collateralized mortgage obligations or collateralized debt obligations. Corporate issuers tend to prefer not to issue subordinated bonds because of the higher interest rate required to compensate for the higher risk, but may be forced to do so if indentures on earlier issues mandate their status as senior bonds.
Also, subordinated debt may be combined with preferred stock to create so-called monthly income preferred stock, a hybrid security paying dividends for the lender and funded as interest expense by the issuer.
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants. In some countries and languages the term "security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition.
In finance, a high-yield bond is a bond that is rated below investment grade. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors.
In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.
In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:
Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.
Preferred stock is a form of stock which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock, but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.
A trust-preferred security is a security possessing characteristics of both equity and debt. A company creates trust-preferred securities by creating a trust, issuing debt to it, and then having it issue preferred stock to investors. Trust-preferred securities are generally issued by bank holding companies. The preferred stock securities issued by the trust are what are referred to as trust-preferred securities.
Structured finance is a sector of finance, specifically Financial law that manages leverage and risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments.
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA ; Junior AAA; AA; A; BBB; Residual.
A capital requirement is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets.
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as lead arrangers.
An asset-backed security (ABS) is a security whose income payments and hence value are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.
The vast majority of all second lien loans are senior secured obligations of the borrower. Second lien loans differ from both unsecured debt and subordinated debt.
A PIK, or payment in kind, is a type of high-risk loan or bond that allows borrowers to pay interest with additional debt, rather than cash. That makes it an expensive, high-risk financing instrument since the size of the debt may increase quickly, leaving lenders with big losses if the borrower is unable to pay back the loan.
In finance, senior debt, frequently issued in the form of senior notes or referred to as senior loans, is debt that takes priority over other unsecured or otherwise more "junior" debt owed by the issuer. Senior debt has greater seniority in the issuer's capital structure than subordinated debt. In the event the issuer goes bankrupt, senior debt theoretically must be repaid before other creditors receive any payment.
Credit enhancement is the improvement of the credit profile of a structured financial transaction or the methods used to improve the credit profiles of such products or transactions. It is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization.
Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.
The word tranche is French for 'slice', 'section', 'series', or 'portion', and is a cognate of the English 'trench' ('ditch'). In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation usually defines the tranches as different "classes" of notes, each identified by letter with different bond credit ratings.
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).