subordinate

What It Is

Subordinate means "ranks beneath." In finance, the term usually refers to the claims a creditor has on a company's assets relative to other creditors.

How It Works

When something is subordinate, it ranks below the claims of other investors. The opposite of subordinate is "senior."

A subordinate claim on a company's assets is payable only after the claims that are senior have been paid. For example, let's assume Company XYZ has $100 million in assets, but it has filed Chapter 7 bankruptcy and is liquidating. Let's also assume that Company XYZ has $125 million in total debt in the following categories: $95 million of Series A senior debt, $10 million of Series B subordinated debt, and $20 million owed to suppliers (called general creditors).

The Series B creditors are subordinate to the Series A creditors. So, of Company XYZ's $100 million in assets, the Series A creditors now own $95 million of them. This leaves only $5 million for the other Series B bondholders. Although this doesn't repay all of the $10 million owed to them, it is better than nothing, which is what the suppliers (who are owed $20 million) will get in this situation.

In general, the most senior level of debt a company has is its "secured" debt. Secured debt is collateralized by some specific asset -- usually land, equipment or cash -- that must be set aside so that secured debtholders get paid no matter what (similar to a house being collateral for a mortgage).

After the senior secured debtholders, other lenders have fewer and fewer claims on assets. Debentures (which are unsecured -- meaning there is no collateral set aside) are subordinate to secured debt. General creditors and subordinated debentures are at the bottom of the lender totem pole as the most subordinate of all the creditors. Shareholders are subordinate to all creditors, which is why they almost always receive nothing at all in the event of liquidation.

Why It Matters

The more subordinate the creditor, the weaker its claim on the company's assets. The weaker this claim, the higher the risk that the creditor will be left with nothing if the borrower defaults. This is why the more subordinate a security is, the higher the return investors demand. This is also why shareholders should always demand a higher rate of return than debtholders.

The difference in returns between a company's senior debt and its subordinated debt may not be big if the borrower is exceptionally creditworthy. But for less creditworthy borrowers, the spread can be significant. If the creditor or bondholder is confident in the company's ability to repay, the higher returns associated with subordinate securities can present exceptional opportunities.

Source: Investing Answers