Unlike equity, bonds are a debt instrument, meaning that they represent a loan given to the issuer. Therefore, the principal amount extended has to be repaid with interest or return. Moreover, being a debt asset, bonds receive preference in repayment over stocks if the issuer winds up its business. While this repayment preference of bonds over stocks is well known, investors often miss the fact that there exists a repayment hierarchy even among debt instruments and bonds. It means that while some bonds are repaid before other debts, others might be repaid after, in case the issuer moves to dissolve or wind up their business.
Therefore, as the Indian bond market witnesses exponential growth, with outstanding bond issuances rising from ₹17.5 trillion in FY2015 to ₹53.6 trillion in FY2025, let us decode what subordinated bonds are. It will help investors understand the repayment priority of issuers and undertake investment after a comprehensive analysis of risk, liquidity, capital safety, and more.
What is a Subordinated Bond?
Bonds that rank below other debt in the repayment hierarchy if the insurer goes bankrupt or winds up its business are called subordinated bonds. Also known as a junior bond or a subordinated debt, these instruments are repaid after senior debts, like secured loans, senior bonds, and others, are settled. While senior debt gets priority, junior debt or subordinated bonds are repaid after priority debts are met, if the company liquidates.
Therefore, due to the high risk profile of these bonds, they also have a higher yield compared to regular bonds. Moreover, although in the repayment ladder, subordinated bonds sit below priority or senior debt, they still enjoy repayment priority over equity.
Subordinated bonds are mostly unsecured, meaning that they are not backed by any collateral. It is important to understand how these bonds operate to get a nuanced understanding of these bonds.
How does a Subordinate bond work?
A business derives its capital from various sources; while some are its own funds, others can be borrowed. Bonds represent a type of borrowed fund which must be repaid, like any other debt. However, businesses have a repayment priority ladder, meaning that while some sources of capital receive first priority in repayment, others come in later.
Debt is repaid before equity because equity represents ownership. However, even among debts, some liabilities are repaid before others.
- Senior Debt is at the top of the repayment ladder, and repaid first in case the company liquidates. Some senior bond types are secured loans, senior bonds, etc.
- Junior Bonds or Subordinated bonds are repaid after senior debt is cleared.
- Equity represents ownership and is repaid after all debts are settled.
Therefore, subordinated bonds are repaid before equity but after senior debts. However, this structure comes into question when the company moves towards dissolution. However, if this does not happen, subordinated bonds complete their lifespan.
- Issue: Subordinated bonds are primarily unsecured bonds, meaning they are not issued against any collateral. Furthermore, these bonds carry a higher yield than regular bonds.
- Maturity: After regular coupon payment, on maturity, the issuer repays the principal along with any outstanding interest.
Also note that often subordinated bonds have a loss absorption feature, meaning regulators may allow principal and capital payments, accrued to subordinated bonds, to be delayed, converted into equity, and so on.
Let us take an example to understand subordinated bonds and their operation better.
Examples of Subordinated Bond
Since the primary differentiating feature of subordinated bonds is their treatment during issuer dissolution, the illustration below provides further clarity on the matter.
XYZ bank has a secured loan worth ₹100 crores against a ₹150 crore asset, ₹700 crore senior bonds, ₹200 crore subordinated bonds, and ₹100 crore equity. XYZ is now moving towards a dissolution and has ₹800 crores to repay all its debt. The table below illustrates the treatment of each of the liabilities.
| Liabilities | Treatment During Dissolution |
| ₹100 crore secured loan | The ₹150 crore asset will be liquidated to repay the ₹100 crore loan |
| After the settlement of the secured loan, ₹50 crore would be left of the liquidation. Therefore, the total corpus used to settle liability now becomes ₹850 crores | |
| ₹700 crore senior bonds | The full bond liability will be settled |
| After this, ₹150 crore will be left to settle liabilities | |
| ₹200 crore subordinated bonds | Only ₹150 crore will be used to settle it on a pro-rata basis |
| Equity | This won’t be repaid, resulting in an investment loss among equity holders |
There are different types of subordinated bonds; investors must understand each of them for a nuanced take on the subject.
Types of Subordinated Bond
Discussed below are the key types of subordinated bonds.
- Mezzanine debt: In the capital structure, this financial security lies between conventional debt and equity. Mezzanine debt functions similarly to a loan with set interest rates, but it frequently has equity-linked features like conversion rights or warrants that let investors take on more risk in return for possible gains.
- High-yield bonds: Bonds with lower credit ratings but higher interest rates are called high-yield bonds. Their higher return is targeted to offset the higher default risk. However, investors must note that although some high-yield bonds are organised as subordinated, they are often senior unsecured.
- Convertible subordinated debt: This bond type enables you to turn debt into equity at a ratio that has been predetermined. If the business does well, this allows profit sharing.
- Payment-in-kind notes (PIK): In this bond type, the issuer saves funds during growth stages by adding interest to the principal rather than paying periodic interest in cash.
- Subordinated notes: They are short-term investment instruments, used to fund interim business needs, rather than long-term growth or sustenance objectives.
- Callable subordinated debt: The term callable implies inviting repayment before maturity. Therefore, this subcategory enabled redemption before bond maturity.
Like any investment instrument, subordinated bonds have certain covenants and restrictions, which must be adhered to and understood before investing.
Covenants and Restriction
In India, subordinated bonds are governed by the RBI prudential norms, SEBI regulations, and the Companies Act requirements. The structure of frameworks and covenants not only aims to uphold investor protection but also avoid undue constraints on issuer operations. Discussed below are some of these covenants and restrictions.
- No restrictive clause: The RBI defines subordinated debt as an unsecured instrument, completely paid off, subordinated to other creditors, and free from restrictive clauses. This means that tight operational limitations that would impede regular management discretion cannot be placed on the issuer.
- Use of proceeds: The proceeds of subordinated debt are often not permitted for speculative trading or short-term working capital; instead, they are intended to support long-term funding or capital adequacy.
- Lack of early redemption: RBI-qualifying subordinated debt cannot be redeemed at the holder’s request without the regulating authority’s (RBI) approval.
- Non‑payment of interest or principal: Unless RBI laws specifically call for a moratorium or delay, failure to pay interest or principal on the due date constitutes an event of default.
- Breach of Covenants: Although Indian practice warns that covenants should not be so wide that small governance or technical breaches immediately accelerate the debt, any major breach of covenants or false claims that are detrimental to debenture holders may lead to default.
Conclusion
Understanding the repayment preference structure in the case of company or entity dissolution is important to anticipate the risk profile of an asset. While debt is issued before equity, there exists a hierarchy even among debt. Subordinated bonds refer to bonds that are repaid after senior bonds but before equity. Due to this, they earn a greater yield compared to regular bonds. The primary objective of these bonds is to allow corporates greater room to gain flexible capital, without diluting equity, whilst enabling investors to make debt investment growth-oriented. However, the assets still remain riskier compared to regular bonds. Therefore, investors must optimally analyse their profile and asset characteristics before investing, whilst prioritising optimal diversification.
FAQ‘s
If the issuer goes bankrupt or liquidates, a subordinated bond receives lower repayment priority than senior bonds. Senior bondholders receive the first payment from available assets, followed by junior bondholders. Due to their weaker claim on assets, subordinated bonds are often seen as riskier than senior bonds and are paid higher yields.
Subordinated bonds often pay higher yields to compensate investors for their lower repayment priority and increased credit risk. Since these bonds are paid after senior obligations in the event of failure, investors frequently seek a higher yield to compensate for the greater uncertainty and potential loss risk.
Subordinated bonds have a higher credit risk because repayment is based on leftover assets after senior debts are settled. In times of financial hardship, issuers may withhold payments or face write-downs, particularly on bank-issued instruments. Market risk and interest rate sensitivity can also influence price volatility.
A subordination agreement legally establishes the repayment hierarchy among several creditors. It states that junior bondholders will be paid only when senior creditors are satisfied. This contractual arrangement specifies rights and obligations, avoiding ambiguity in insolvency procedures and defining the issuer’s entire capital framework.
The recovery rate for subordinated bonds is typically lower than that of senior bonds because of their junior ranking in liquidation. Actual recovery varies depending on the issuer’s asset base, debt structure, and economic conditions. In some cases, recoveries may be limited or significantly reduced.
