subordinated debt

When a company goes bankrupt, the remaining money usually isn’t enough for everyone. That’s why the law establishes an order determining who gets paid first. Subordinated debt ranks far back in this order — other creditors, meaning individuals or institutions to whom the company owes money, are paid first. Only once these have been paid in full do holders of subordinated debt get their turn. Often, nothing is left by then. This sounds unattractive, which is why lenders demand higher interest rates for this risk than for an ordinary loan.

Ranking and risk in the event of insolvency

The order in which creditors are paid in the event of insolvency is called the ranking. At the very top are secured creditors — for example, a bank that has secured a loan against a property. Behind them come unsecured creditors such as suppliers. Subordinated creditors come only after that. Shareholders, meaning the owners of the company, stand even further back.

A concrete example: After insolvency, a company still has ten million euros. It owes a bank 8 million (senior) and a bondholder 5 million (subordinated). The bank receives its 8 million in full. Only 2 million remain for the bondholder — meaning they lose 3 million. A common misconception: subordinated doesn’t automatically mean unsafe. As long as a company is healthy, it pays interest and principal as normal. The risk only fully materializes in the event of insolvency.

Why companies deliberately raise subordinated capital

From the company’s perspective, subordinated debt has a decisive advantage: rating agencies and banks partly treat it like equity. Equity is the money that the owners themselves have put into the company — it serves as a buffer for bad times. The more buffer a company has, the more creditworthy it is considered. Subordinated capital provides this buffer effect without the company having to bring in new owners.

This is particularly important for banks. Regulatory authorities prescribe how much capital they must hold as a safety cushion. Certain subordinated bonds — so-called Tier 2 bonds — count toward this required capital. Banks therefore use them specifically to meet their regulatory requirements without having to issue shares.

For small and medium-sized companies, subordinated loans are also a way to obtain fresh money when normal bank financing isn’t possible. The price for this is the higher interest rate, which reflects the lender’s increased risk.

Subordinated debt in news and financial products

In the business press, the term mainly appears on two occasions: during banking crises and in connection with corporate bonds. In the 2008 financial crisis, subordinated bonds of major banks became practically worthless when the institutions ran into trouble. Investors who had bet on the high interest rates lost their entire capital. This made the principle widely known to the general public.

In the field of start-up financing, the term is encountered as a “subordinated loan.” In this arrangement, an investor lends a young company money at normal interest rates but contractually waives the right to be paid before other creditors in case of problems. This allows the start-up to more easily obtain further loans, because external banks know that they will be first in line in a worst-case scenario.

Subordinated loans are also the most common contractual form in crowdinvesting — that is, when many private individuals jointly invest in a company. Platforms are legally required to point out the risk of loss. The higher interest rate sounds tempting; the subordination in the event of insolvency is the flip side of that.