Subordinated debt

When a company is liquidated, its creditors are not paid all at once. They queue, and where you stand in the queue decides how much you recover. Subordinated (or junior) debt stands near the back.

The workbook classifies bonds based on seniority — senior or junior (subordinate) — depending on their claim on the company's assets at the time of liquidation, and states the consequence directly: bonds lower in priority of claims offer higher yields to compensate for the risk inherent in them.

Subordinated bonds, in its words, pay higher coupon but are riskier as these bonds are paid out just before the equity holders at the time of liquidation. In India, banks issue subordinate bonds to shore up their Tier II capital as per the capital adequacy requirement.

The queue in liquidation, as the workbook describes it:

Security is a separate axis. The workbook also classifies bonds as secured, backed by specific assets and paid first out of the assets collateralised against them, with a higher recovery rate, and unsecured, issued on the company's name and reputation. A bond can be unsecured and senior, or unsecured and subordinated.

Banks' subordinated bonds. The workbook's description of Tier 2 (AT2) bonds shows what bank subordinated debt looks like:

The credit spread — the difference between corporate and government bond yields — is how the market prices this extra risk.

Illustrative company, balance sheet and recovery.

A company goes into liquidation. After costs, its assets realise Rs 300 crore. Its claims:

The queue pays out in order:

The subordinated holders lose Rs 50 crore. For years they collected a 2 percentage point higher coupon than the senior lenders — on Rs 150 crore, Rs 3 crore a year more — and this is the scenario that coupon was paying for.

If the assets had realised only Rs 200 crore, senior debt would still recover in full and the subordinated holders would recover nothing, ranking only just ahead of equity.

Chapter 1 (Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Markets) covers senior and subordinated debt in section 1.3.6, "Based on Seniority", after secured, unsecured and credit enhanced bonds in section 1.3.5, and describes bank Tier 2 subordinated bonds among other instruments in section 1.3.7. Expect a question on who is paid just before equity in liquidation and on why junior debt yields more.

• Subordinated debt is paid just before equity, after senior debt.
• Lower priority = higher yield. Senior debt carries lower interest rates.
• Secured versus unsecured is a different classification from senior versus subordinated.
• Indian banks issue subordinated bonds for Tier II capital — not for Tier I, which is where AT1 bonds sit.
• Bank Tier 2 bonds rank behind depositors, unsecured creditors and senior bonds.
• Tier 2 bonds: minimum 5 years, no put, call after 5 years with RBI approval.