What it means
Every borrower has a pecking order of creditors. If the business fails, the money that is raised from selling its assets is paid out in a fixed order set by the contracts and the law.
Debt that is not contractually ranked below anything else is unsubordinated, and it receives payment ahead of the debts that are subordinated. Unsubordinated debt can be secured or unsecured.
A secured lender has a claim over particular assets, while an unsecured but unsubordinated lender ranks equally with the borrower's other ordinary unsecured creditors. Equal ranking is described by the Latin term pari passu, which means on the same footing, so these lenders share any shortfall in proportion to their claims.
Because unsubordinated lenders face less risk of loss, they accept lower interest rates than holders of subordinated debt. Subordinated lenders are paid more in return for being at the back of the queue.
The same company can therefore have several layers of debt, each with its own price, and its blended cost of borrowing reflects the mix. For a business, the layers matter when it plans further borrowing.
A new lender will ask how much unsubordinated debt already exists, because that debt takes priority and reduces what is left for newcomers. Bond documents often limit the amount of senior debt a company can add.
The term also has a regulatory use. Banks and other financial institutions issue senior unsubordinated bonds as a routine funding source, and regulators sometimes require some debt to be capable of absorbing losses in a crisis.
Investors should read the terms to see exactly where a bond ranks. Ranking can also change over time.
A company may later agree to subordinate existing debt to a new lender as a condition of fresh funding, and a debt that was once unsubordinated then falls down the queue. Holders usually have to consent, so the bond documents should be checked for how such changes are approved.
In practice
Real-world examples.
Example
A manufacturer has a $10,000,000 bank loan and $3,000,000 of loan notes that are subordinated to the bank. The bank loan is unsubordinated debt and is repaid first. The note holders earn a higher rate of interest because of their lower ranking.
Example
A bank issues $500,000,000 of senior bonds to fund its lending. The bonds are unsubordinated, so in a failure they rank above the bank's subordinated bonds and its shares. Investors accept a lower yield for that higher ranking.
Example
A retailer is negotiating a new loan. The lender asks for a schedule of all existing unsubordinated debt and sets a limit on total senior borrowing at 3 times operating earnings. The finance team has to plan upcoming purchases within that limit.
Formula
Calculation
Recovery for each class = the lower of (claim) and (proceeds remaining after higher-ranking classes are paid)
Suppose a company fails and, after costs, $6,000,000 is available to its debt holders in this layer. Unsubordinated debt claims total $5,000,000 and subordinated debt claims total $2,000,000. The unsubordinated creditors are paid in full: $5,000,000. The remaining 6,000,000 - 5,000,000 = $1,000,000 goes to the subordinated creditors, who recover 1,000,000 / 2,000,000 = 50% of their claims. If the proceeds had been only $4,000,000, the unsubordinated creditors would have recovered 4,000,000 / 5,000,000 = 80% and the subordinated creditors nothing.Case study
Seen in the real world.
Pinecrest Hotels is an illustrative, fictional company that borrowed $20,000,000 from a bank and later raised $8,000,000 through subordinated notes to fund a refurbishment. When bookings fell during a downturn, the company could not meet its payments and entered a restructuring.
The company's assets were valued at $22,000,000. Because the bank loan was unsubordinated, it was repaid in full from that value, leaving $2,000,000 for the note holders, who recovered 25% of their $8,000,000.
The note holders had earned a higher return in the good years to compensate for this risk. The illustrative lesson is that ranking decides who bears losses, and a higher interest rate is the price of accepting a lower rank.
Watch out
Common mistakes.
- Assuming that unsubordinated debt is always secured, when it can also be unsecured and simply rank equally with other ordinary creditors.
- Assuming that senior debt is risk-free, when unsubordinated lenders can still lose money if the borrower's assets are worth less than the debt.
- Ignoring the ranking of debt when comparing yields, which leads to the wrong view that a higher-yield bond is simply a better deal.
Questions
People also ask.
Is unsubordinated the same as senior?
In most contexts yes, because both describe debt that is not ranked below other debt, although senior debt can sometimes mean debt that ranks above other unsubordinated debt.
Why do borrowers issue subordinated debt at all?
It is a way to raise more money when the senior lenders will not lend further, and in banks it can count towards regulatory capital.
What does pari passu mean?
It means that creditors of the same rank are treated equally and share losses in proportion to their claims.
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