Subordinated debenture definition
/What is a Subordinated Debenture?
A subordinated debenture is a bond classified lower than more senior debt in the event of a default. This means that the holders of more senior securities are paid first, before any residual funds are made available to the holder of the subordinated debenture. Given the higher risk of nonpayment, this security pays out a relatively high interest rate, either because it has a high coupon rate or because investors are buying it at a discount from its face amount.
A subordinated debenture can be relatively low risk, as long as the borrower has a proven stream of cash flows that can be used to pay down its obligations, and especially if it also has a large asset base that can be used to pay off both senior debt and the subordinated debenture.
Characteristics of a Subordinated Debenture
The key characteristics of a subordinated debenture are as follows:
Unsecured nature. Unlike secured bonds, subordinated debentures are not backed by collateral. Investors rely on the issuer's creditworthiness and promise to repay.
Subordination. In the event of bankruptcy or liquidation, subordinated debentures are paid after senior debt but before equity holders. This higher risk typically means higher interest rates for investors.
Higher interest rate. To compensate for the increased risk, subordinated debentures usually offer higher interest rates compared to senior debt instruments.
Maturity period. Subordinated debentures generally have longer maturity periods, ranging from 5 to 30 years, depending on the terms of the bond.
Special covenants. Issuers may include specific covenants to protect their position or make the debentures more attractive to investors, such as restrictions on issuing more senior debt.
Callable feature. Many subordinated debentures include a call option, allowing the issuer to redeem the bond before maturity under specific conditions.
Lower credit rating. Subordinated debentures typically have lower credit ratings due to their unsecured and junior status, reflecting their higher risk profile.
Market risk. Subordinated debentures are subject to interest rate risk and market risk, with their value fluctuating inversely to interest rate movements.
Terms Similar to Subordinated Debenture
A subordinated debenture is also known as a junior security.