What Is the Difference Between Subordinated Debt and Senior Debt?
The difference between subordinated debt and senior debt is the priority in which a firm in bankruptcy pays the debt claims. 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.
Key Takeaways:
- Subordinated debt and senior debt differ in terms of their priority if a firm faces bankruptcy or liquidation.
- Subordinated debt, or junior debt, is less of a priority than senior debt in terms of repayments.
- Senior debt is often secured and is more likely to be paid back while subordinated debt is not secured and is more of a risk.
Understanding the Two Types of Debt
The fundamental implications of the two types of debt are the risk to the creditor.
Subordinated Debt
With subordinated debt, there is a risk that a company cannot pay back its subordinated or junior debt if it uses what money it does have during liquidation to pay senior debt holders. Therefore, it is often more advantageous for a lender to own a claim on a company's senior debt than on subordinated debt.
Senior Debt
Senior debt is often secured. Secured debt is debt secured by the assets or other collateral of a company and can include liens and claims on certain assets.
When a company files for bankruptcy, the issuers of senior debt, typically bondholders or banks that have issued revolving lines of credit, have the best chance of being repaid. Next in line are junior debt holders,preferred stockholders, andcommon stockholders. In some cases, these parties are paid by selling collateral that has been held for debt repayment.
Example of Subordinated Debt vs. Senior Debt
If a company files for bankruptcy, the bankruptcy courts prioritize the outstanding loans that must be paid using the company's liquidated assets.
Any debt that has a lesser priority over other forms of debt is considered subordinated debt. Any debt with higher priority over other forms of debt is considered senior debt.
For example, a company has debt A that totals $1 million and debt B that totals $500,000. Debt A is senior debt, and debt B is subordinated debt. If the company files for bankruptcy, it must liquidate all of its assets to repay the debt. If the company's assets are liquidated for $1.25 million, it must first pay off the $1 million amount of its senior debt A. Only half of the remaining subordinated debt B is repaid due to the lack of funds.
Key Differences
Senior debt has the highest priority and, therefore, the lowest risk. Thus, this type of debt typically carries or offers lower interest rates. Meanwhile, subordinated debt carries higher interest rates given its lower priority during payback.
Banks typically fund senior debt. Banks assume lower-risk senior status in the repayment order because they can afford to accept a lower rate given their low-cost sources 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, 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, orreceivables. 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.
Special Considerations
One of the benefactors of subordinated debt is banks. Banks raise subordinated debt when rates on these loans are lower than other forms of raising capital. This comes as many banks are considered low risk given the increased regulatory scrutiny since the financial crisis of 2007 to 2008. Subordinated debt has become a relatively easy way for banks to meet capital requirements without having to dilute their shareholder base by raising capital.
FAQs
Key Differences
What is meant by senior debt? ›
What Is Senior Debt? Senior debt is borrowed money that a company must repay first if it goes out of business. Each type of financing has a different priority level in being repaid if the company goes out of business.
What is the point of subordinated debt? ›
Although non-financial companies do issue subordinated debt, the main issuers are financial companies and insurers, and especially banks. Banks issue subordinated debt to fulfil regulatory capital requirements and European regulators recognise subordinated debt as capital.
How is senior debt different from long term debt? ›
What makes senior term debt different than a regular debt is that it can include a bullet payment at the maturity date. It means paying the remaining value of the debt that is owed to the lender.
What is the term subordinated debt? ›
Subordinated debt is a lax loan or bond that positions below more senior loans or securities with claims on assets or earnings. Subordinated debentures are also known as junior securities. In the case of default, creditors owning a subordinated debt will not be paid until the senior bondholders are paid in full.
Can senior debt be subordinated? ›
Investors have much to gain from offering senior subordinated debt to clients. The high returns alone are valuable enough, but subordinated debt arrangements also enable an investor to reap further benefits when a company meets the financial goals it laid out when applying for the loan.
What is an example of a subordinated loan? ›
Some examples of subordinated loans include high yield bonds, mezzanine with and without warrants, Payment in Kind (PIK) notes, and vendor notes, all in order of priority from highest to lowest.
What are the disadvantages of subordinated debt? ›
Disadvantages
- It has a high risk along with the high return that it provides to investors. ...
- They have a lower priority during repayment. ...
- The market volatility significantly affects this type of debt if the interest rate is floating, resulting in changes in market value.
To reiterate from earlier, subordinated debt is riskier than senior debt because of its lower placement in the priority of claims (and thus, these sorts of securities carry higher interest rates than senior debt).
Why do banks issue senior debt? ›
Hypothetically, in the event of bankruptcy (or liquidation), senior debt lenders hold seniority above all other stakeholders (including other lenders). Therefore, senior lenders are the most likely to receive full recovery of the original capital provided, even if the borrower were to default and become insolvent.
Senior Debt, or a Senior Note, is money owed by a company that has first claims on the company's cash flows. It is more secure than any other debt, such as subordinated debt (also known as junior debt), because senior debt is usually collateralized by assets.
What is the most senior debt? ›
Various debt obligations can have different seniority rankings. This, obviously, implies different priority of payment. The most senior or highest-ranking debts have the first claim on the assets in the event of default.
What are other names for subordinated debt? ›
- Subordinated debt is also known as a subordinated debenture and it gets repaid only after senior debtors get paid in full.
- On the balance sheet of a company, subordinated debt is listed after unsubordinated debt and it's classified as a long-term liability.
Subordinated lenders fall into the second lien position and aren't repaid until the senior lender is “made whole” in a default situation. Senior lenders are typically asset-based, whereas subordinate lenders can be any financial institution.
What is the interest rate on subordinated debt? ›
Typically, this type of debt carries an interest rate somewhere between 13% and 25%, and may also include equity kickers (or extra benefits) to further compensate the lender for the high risk and lack of asset security.
What are examples of senior debt? ›
Any debt with higher priority over other forms of debt is considered senior debt. For example, a company has debt A that totals $1 million and debt B that totals $500,000. Debt A is senior debt, and debt B is subordinated debt. If the company files for bankruptcy, it must liquidate all of its assets to repay the debt.
How is senior debt calculated? ›
How is senior debt calculated? Senior loan or debt is 2 to 3 times EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization). Subordinated debt, on the other hand, is calculated differently.
How do you calculate senior debt? ›
The entire senior debt portion commonly accounts for 50% of funding in an acquisition, which roughly equates to two to three times debt to EBITDA or twice the interest coverage.
