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Each debt comes with a seniority ranking that dictates the priority of its repayment when the borrower defaults. This priority occurs on the borrower’s side. However, the lender also gets impacted by it. Usually, seniority rankings are crucial when a company accumulates debt finance from several sources. If the company defaults, it is critical to establish which debt gets prioritized over the other.
Debt can fall into several classes based on its priority. Similarly, these classes may have further divisions that further divide them. One such division includes subordinated debt.
What is Subordinated Debt?
Subordinated debt is a classification within seniority ranking. It represents an unsecured debt that gets a lower priority than senior debt. Usually, subordinated debt falls at the bottom of the seniority ranking order. Another name often used to describe these debts is junior debt. Subordinated debt may include more classes based on the priority of the underlying debt.
Subordinated debt receives the lowest priority in the seniority ranking. However, it still falls above equity. If a company defaults, senior debt lenders receive priority over the recovered funds. The residual amount, if any, goes to subordinated debt lenders. Therefore, this debt comes with a higher risk to the lender. Consequently, these lenders charge a higher interest rate on their loans to compensate for that risk.
How does Subordinated Debt work?
Companies obtain debt from various sources. Usually, companies don’t rank these debts since they must contribute towards all repayments regularly. However, when a company defaults, all lenders seek to recover losses. At this point, the company may be bankrupt or get liquidated. This process involves disposing of the company’s assets to compensate finance providers.
When repaying these providers, the process follows a specific order. Usually, debt falls above equity. Within debt, there are further classifications which include secured, unsecured, senior, subordinated, or junior debts. Usually, secured and senior debts receive the highest priority. Subordinated debts only receive a share of the disposed-of assets once the above lenders get compensated.
What is the difference between Subordinated and Senior Debt?
The difference between subordinated and senior debt comes from their positions on the seniority ranking. As stated, senior debt falls first on this ranking since it usually includes secured loans. On the other hand, subordinated debt receives a lower ranking. Therefore, it gets paid last if a company defaults on its loans. Senior debt may be loans received from banks. Contrastingly, subordinated debt includes mezzanine debt.
Another difference between the two types of debt comes from the associated debt terms. Usually, senior debt is safer for the lender. Therefore, they charge a lower interest rate on these debts. Since these debts are also secured, they come with a lower risk to the lender. On the other hand, subordinated debt comes with a higher interest rate due to its unsecured nature. Therefore, the risks associated with these debts are also higher.
Conclusion
Subordinate debt represents the lowest priority debt instruments on the seniority ranking. It includes unsecured loans that get paid last if a company defaults on its loans. Similarly, it comes after secured and senior debt, which receives the highest priority on the ranking. Subordinated debt comes with higher risks to lenders resulting in an increase in interest rates.
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