When a company is forced to file bankruptcy and its assets must be liquidated to pay investors, bondholders are first in line to get their money back. Stockholders then receive whatever money -- if any -- is left. While bond owners receive first priority to be repaid if a company defaults, all bonds are not created equal. Some bonds have higher priority than others. Subordinate debenture bonds hold the absolute lowest rank in the bond industry.
Corporate bonds are either secured or unsecured. One example of of a secured bond is a mortgage bond, the type often issued by utility companies. If the utility company were to fall on hard financial times and go out of business, investors would be able to sell the utility company's equipment and recoup some of their losses. Transportation companies issue bonds secured by their equipment -- airplanes, buses and railroad cars. Secured bonds also are known as senior debt because they receive first priority.
Debenture bonds are unsecured. They are backed only by the creditworthiness of the company that issues them. Some companies even issue subordinate debenture bonds, which are even riskier in the event of bankruptcy. Seniority becomes an important issue if bankruptcy ever becomes a reality. Holders of subordinate debenture bonds will be the last of all bondholders to be repaid.
Investors who take more risk usually expect to earn more return. The same is true when it comes to subordinate debenture bonds. Debenture bonds tend to pay higher coupons than bonds secured by collateral. Subordinate debenture bonds pay the highest coupon rates because they are riskier than the other classes of bonds with higher priority.
Investors who own subordinate debenture bonds receive a higher interest payment throughout the life of the bond. Most subordinate debenture bonds pay off fine. And, in any event, bondholders still have priority over all stockholders if a company goes bust. Holders of secured bonds accept a lower coupon for the security of knowing they can sell the company's assets and get paid first. But some of the company's assets may not even be marketable, and who knows what money will be left if lawyers get involved in the bankruptcy and litigation drags on for years.
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