Subordinated debt: what it is – Dictionary of Economics

Subordinated debt concept

It is a fixed-income instrument issued with lower characteristics than normal issues, mainly because its holder is behind all common creditors in collection preference (priority order). In the case of credit institutions, this debt is considered, together with preference shares, a hybrid capital instrument, in the sense that it meets certain requirements that partially make it similar to ordinary capital of credit institutions, and is computable as entities’ own resources.

Characteristics of suborned debt

Subordinated debt is a bond identical to simple bonds, but the difference is in its “collection priority”, since, in the event of liquidation, the collection of these bonds by their holders is “subordinated” to the rest of the common creditors has collected its debt If the subordinated debt has the category of ‘special’ it can become perpetual and in this case, if the issuer incurs accounting losses, the payment of interest is deferred (cumulative) or lost (non-cumulative) The issuer may even be able to absorb all the debt if it has exhausted the reserves and resources comparable to capital (such as preferred shares), that is, an investor in this type of product may lose 100% of the amount invested It is therefore important to know if the subordinated debt is ‘non-special’ or ‘special’ and, in the latter case, if it is ‘cumulative’ or ‘non-cumulative’.

Profitability – risk: Its differential risk – leaving aside the global ‘issuer risk’ and that of the variation in interest rates in the market – is in its ‘subordination’, that is, it is a bond that the issuer, if it goes bankrupt, will repay if and only if the rest of the creditors have collected. Whoever acquires subordinated bonds must analyze and assess the risk of bankruptcy of the issuer before the maturity of that bond and demand the return in accordance with that analysis. Obviously, the profitability of a ‘special non-cumulative subordinate’ will be greater than that of a ‘special accumulative subordinate’ and the latter will have greater profitability than a ‘non-special subordinate’.

Any subordinated debt will have a higher return than the ‘pure’ non-subordinated debt of the same issuer.

Liquidity: Like all hybrid products, its liquidity is scarce. It will be difficult to get rid of it in the secondary market without sacrificing a high percentage of what was invested.

Taxation in personal income tax: They are fixed-income securities with an explicit yield, therefore the interest receives the RCM rating to be included in the BIA. The yield obtained in its amortization, transmission, exchange or conversion is also considered RCM to be included in the BIA.

Xavier Puig. Doctor in Business Administration and Management and director of the Banking and Finance programs at UPF Barcelona School of Management.