Subordinated debt is a form of corporate debt that carries relatively high risk and high yields as an investment, because holders of subordinated debt are at a higher risk of not being paid back should the corporation go into financial distress than are holders of senior debt. Instruments and securities that use subordinated debt include asset-backed securities, in which debt is divided up into tranches and each tranche has its own credit rating.
When a company goes bankrupt or defaults, it has too much outstanding debt to pay off. If that debt is divided among many people, as is the case when the company has issued bonds and otherwise sold its debt, there is a specific hierarchy that determines who gets paid first. The debt that is first in line for payment is called senior debt, while the debt below that is called subordinated debt. Subordinated debt carries more risk than senior debt because of the chance that holders of subordinated debt might not get their money back. Subordinated debt may or may not be secured.
Issuing Subordinated Debt
Because subordinated debt needs to carry a higher interest rate to compensate investors for the additional risk, corporations are less inclined to sell subordinate debt to the general investing public. Banks may issue subordinated debt as well. For example, Barclay's issues a variety of types of subordinated debt, in both fixed-rate and floating-rate forms.
Subordinated Debt Securities
Subordinated debt is also useful in the construction of asset-backed securities and other similar financial products. In an asset-backed security, the debt is divided into portions called tranches, and each tranche receives its own credit rating and has its own terms. Prominent examples of asset-backed securities include the mortgage-backed security, which secures the debt with mortgages of varying quality.
Other Subordinate Securities
Subordinate debt is part of other, more exotic securities and instruments. For example, mezzanine debt is a kind of subordinated debt that can be converted into stock using an embedded option called a warrant. Mezzanine debt is a hybrid security; it is issued like a bond but acts like a stock. Subordinated debt also forms part of collateralized debt obligations and similar products, in which a variety of assets are pooled and sold in tranches.
Andrew Gellert is a graduate student who has written science, business, finance and economics articles for four years. He was also the editor of his own section of his college's newspaper, "The Cowl," and has published in his undergraduate economics department's newsletter.