What is subordinated debt?
A subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is a credit whereby the creditor is subordinated in the event of bankruptcy of the debtor: the subordinated creditor enters bankruptcy in the order of creditors, thus the unsecured (‘ordinary’) creditors such as the employees and the banks.
Subordinated loans do have priority over shareholders, partners or investors. Subordination can be achieved by contractually agreeing with each other.
Because of these conditions, the creditor runs a higher risk that he will not be reimbursed part of his credit. To compensate for this, a higher interest rate is usually paid. Sometimes the interest is even profit-dependent. The lender, if he is a private individual, does not have to pay tax on the interest received to the tax authorities. However, the loan granted is included in Box-III capital and is taxed at the statutory rate if the total capital exceeds the exemption.
Usage of subordinated debt
Subordinated loans often make it possible for a company to become extra attractive to invest in to banks and investors.
When the company goes bankrupt, the subordinated creditors take the first blow. The subordinated loan therefore acts as a sort of “cushion”. It is a means to generate confidence in certain investment transactions. A bank, investment company or investment manager who has set up the transaction and enters a subordinated loan himself shows that it is also “serious” to him.
Subordinated loans are in practice only provided by and to companies. Due to the nature of the loan, it can sometimes be counted in equity. Providers of subordinated loans are often the parent company of the company or large banks, which can better assess the risk. Governments also often issue subordinated loans as a form of subsidy. Banks themselves also draw subordinated loans as a financing form.
The reason is that a subordinated loan is partially included in the guarantee capital so that banks can comply with the tier 1 and tier 2.standards of “Basel”. This often involves perpetual subordinated bonds (English: perpetuals). There is no repayment obligation, but the issuer usually reserves the right to proceed to repayment at a future time. This is used, for example, when the interest rate falls, in order to refinance more cheaply.
Subordination is very common in securitization transactions. In that case, several subordinated bonds are issued by the issuer. These bonds are not so far subordinated in the event of bankruptcy (securitization vehicles are generally “bankruptcy remote” or “bankruptcy debt”), but the subordination applies in particular to every interest and repayment payment that is made. This creates a ranking list, also called “waterfall”. An example of a “waterfall” could be:
- Payment is first made to all service providers (trust offices, accountants, lawyers’ fees)
- Then to the transaction parties for their transaction-related services
- Then to the A-bondholders
- Then to the B-bondholders
- And everything that remains, however much or little that is, to the (most disadvantaged) C-bond holders.