Introduction

Subordinated debt refers to a type of loan or bond that ranks below other debts (senior securities) in terms of claims on a company’s assets or earnings. In the event of liquidation or bankruptcy, subordinated creditors are paid only after all senior obligations have been settled. Because of this lower priority, subordinated debt carries higher risk—but also typically offers higher returns to compensate investors.

In India, subordinated debt plays a key role in the banking sector, NBFC funding, and corporate finance, especially as part of Tier 2 capital under the Basel III framework for banks.

What Is Subordinated Debt?

Subordinated debt is also known as:

• Junior debt
• Mezzanine debt
• Lower-tier debt

It is debt that, by contract, agrees to be paid after all other more senior debt is repaid. In case of insolvency, if the issuer’s assets are insufficient, subordinated debt holders may receive little or nothing.

Example:

If a company has ₹500 crore in senior loans and ₹100 crore in subordinated debt, and in the event of liquidation it only recovers ₹450 crore, the entire amount goes to senior lenders, and subordinated lenders may lose their entire capital.

Key Features of Subordinated Debt

• Lower Repayment Priority: Paid after senior loans and bonds.
• Higher Interest Rates: Compensates for increased risk.
• Often Unsecured: May not have collateral backing.
• Used as Hybrid Capital: Sometimes considered quasi-equity, especially in bank balance sheets.

Types of Subordinated Debt in India

1. Tier 2 Bonds (Banks & NBFCs)

• Issued by banks to meet regulatory capital requirements under Basel III norms. These are subordinated, meaning in a crisis, they may be written down or converted to equity.

2. Mezzanine Financing (Corporate Debt)

• A mix of debt and equity used in private equity and venture capital, especially during expansion or buyouts.

3. Subordinated Debentures

• Issued by companies for medium- to long-term funding, often with higher coupon rates to attract investors.

Why Do Issuers Use Subordinated Debt?

• To Raise Capital Without Diluting Equity: Subordinated debt does not dilute shareholder control.
• To Improve Capital Adequacy: Especially important for banks and NBFCs.
• To Fund Growth or Expansion: Can be used to bridge capital needs when equity or senior debt is limited.
• Tax Deductibility: Interest paid is often tax-deductible, lowering the cost of capital.

Why Do Investors Choose Subordinated Debt?

• Higher Returns: Coupon rates are significantly higher than senior bonds.
• Diversification: Offers a hybrid exposure between equity and debt.
• Institutional Demand: Attractive to mutual funds, pension funds, and HNIs with a higher risk appetite.
• Not suitable for risk-averse investors due to lower recovery in the event of default.

Risks Associated with Subordinated Debt

• Credit Risk: Higher probability of loss in case of default.
• Liquidity Risk: May not be easily traded in secondary markets.
• Regulatory Risk: Particularly for bank-issued Tier 2 bonds, which may be subject to write-downs under RBI guidelines.
• No Collateral: In most cases, subordinated debt is unsecured.

How Subordinated Debt Fits in Capital Structure

In the capital hierarchy, subordinated debt lies between senior debt and equity:

• Secured Senior Debt
• Unsecured Senior Debt
• Subordinated Debt
• Preferred Equity (if applicable)
• Common Equity

In liquidation, recovery flows from top to bottom, and subordinated debt investors are lower in the repayment order.

Conclusion

Subordinated debt is a critical component of modern capital structures, particularly in banking and corporate finance. While it offers higher yields, it comes with elevated credit and default risks due to its lower repayment priority.

For investors in India, subordinated instruments like Tier 2 bonds or subordinated debentures offer attractive returns but require thorough credit analysis and understanding of the issuer's financial health. In an environment where risk-adjusted returns are key, subordinated debt can play a strategic role in diversified debt portfolios, especially for those with a higher risk appetite.

Reference used: https://www.investopedia.com/terms/s/subordinateddebt.asp

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