Subordinated debt offers higher yields, but it comes with lower repayment priority during financial stress. Understand its meaning, types, risks, and regulatory role before you invest; read the full guide now.
When you compare two bonds issued by the same company and see that one offers a higher interest rate than the other, it is natural to feel drawn toward the higher-paying option. But in financial markets, higher returns rarely come without a reason, and too often, that reason is an increased risk factor.
In fixed-income investing, a higher coupon often reflects structural differences, such as repayment priority, security, tenure, embedded features, or overall credit risk. One structure that carries an in-built risk premium is subordinated debt. It offers higher yields because it ranks lower in the order of claims if the issuer faces financial stress.
In the sections ahead, we explore the meaning of subordinated debt, its workings, types, and much more.
What is the Meaning of Subordinated Debt?
As the name suggests, subordinated debt is a junior or subordinate loan. To understand that, it helps to first know that companies broadly issue two types of borrowings based on repayment hierarchy: senior debt and subordinated debt. Senior debt refers to loans or bonds that carry the highest repayment priority and is settled first if the company faces financial distress.
Subordinated debt, in contrast, is assigned a lower repayment priority by the company during periods of insolvency or stress. It represents an agreement that clearly states it will be repaid only after all senior obligations are fully settled.
As an investor, you should note that subordinated debt is typically unsecured and therefore offers higher returns to compensate for the additional risk. However, it still ranks above equity in the repayment hierarchy. Though in the case of certain bank-issued “AT1” bonds, the debt may be written off even before equity is fully wiped out.
Now that you understand what subordinated debt means, the next logical step is to see how this position actually plays out within a company’s capital structure.
How Does Subordinated Debt Work?
To know how subordinated debt works, you will first have to understand how a company’s capital structure works. A repayment priority layers a company’s capital structure. In liquidation, obligations are paid in this order.
| Rank | Instrument Type | Examples | Repayment Priority |
| 1 | Senior Secured Debt | Mortgages, equipment-backed loans | Highest |
| 2 | Senior Debt | Investment-grade corporate bonds (unsecured), bank borrowings | High |
| 3 | Hybrid Securities | Subordinated debt, mezzanine debt, perpetual bonds | Moderate |
| 4 | Equity | Preference shares, equity shares | Residual claim |
The higher the security ranking in the company’s capital structure, the stronger its claim to repayment and the lower its overall risk. As an investor, you approach greater certainty as you move higher in this hierarchy, and you take on more risk as you move downward.
Subordinated debt sits between senior debt and equity in that structure. For you, this means accepting a lower claim in exchange for a higher return. From the company’s perspective, it becomes a strategic funding tool, allowing it to strengthen its capital base and raise long-term funds without issuing new shares. The terms of the instrument, including tenure, coupon, and subordination clause, formally define your position in the repayment ladder.
Once you see how subordinated debt fits into the repayment ladder, it becomes important to understand that it is not a single, uniform instrument; it comes in multiple structures, each carrying different risk and return dynamics.
Types of Subordinated Debt
Subordinated debt is structured in several forms, each tailored to meet different funding needs and risk appetites.
- Mezzanine debt
It is a financing instrument that sits between traditional debt and equity in the capital structure. Mezzanine debt behaves like a loan (with fixed interest payments) but often includes equity-linked features such as warrants or conversion rights, allowing investors to participate in upside potential in exchange for higher risk.
- Convertible subordinated debt
Allows you to convert debt into equity at a pre-agreed ratio. This gives profit participation if the company performs well.
- High-yield bonds
Lower credit-rated bonds that offer higher interest rates to compensate for increased default risk. (Note: While high-yield bonds are often senior unsecured, some are structured as subordinated.)
- Payment-in-kind (PIK) notes
Instead of paying periodic interest in cash, the issuer adds interest to the principal, conserving cash during growth phases.
- Vendor notes
Seller-financed are loans used in acquisitions, ranking below other debt and carrying elevated risk.
- Callable subordinated debt
Gives the issuer the right to redeem the instrument before maturity.
- Fixed or floating rate instruments
Interest may remain constant or fluctuate with benchmarks like SOFR (which replaced LIBOR in 2023).
- Subordinated notes
Typically, shorter-term instruments are used for interim funding needs.
Now that you know about the various forms subordinated debt can take, you should evaluate why companies and investors use these instruments in the first place, and what trade-offs come attached.
Advantages and Risks of Subordinated Debt
Subordinated debt occupies a strategic space in a company’s capital structure by offering meaningful capital support, but at a calculated cost.
Advantages of Subordinated Debt
1. Higher yield compared to senior debt
Because you rank lower in repayment priority, issuers compensate you with a higher coupon. This makes subordinated debt attractive if you are seeking enhanced income within a fixed-income allocation.
2. Potential capital appreciation in certain structures
Some subordinated instruments, such as convertible or mezzanine debt, allow you to participate in equity upside. If the company performs well, you may benefit beyond just fixed interest payments.
3. Portfolio diversification with structured risk exposure
Subordinated debt offers exposure that sits between senior bonds and equity. For you, this creates an opportunity to diversify across different layers of a company’s capital structure while consciously taking calibrated credit risk.
Disadvantages of Subordinated Debt
1. Higher interest burden
Because you stand behind senior creditors in repayment priority, you are offered higher yields because of the additional risk you are taking. This increases the issuer’s cost of borrowing compared to senior debt.
2. Elevated risk in financial distress
In liquidation or bankruptcy, you are repaid only after senior claims are fully satisfied. Recovery rates of subordinated debt can therefore be significantly lower.
3. Greater price volatility
Subordinated debt is more sensitive to changes in the issuer’s financial health and broader market conditions. If credit risk rises or economic conditions deteriorate, the market value of your investment can fluctuate more sharply compared to senior debt, increasing mark-to-market risk.
Among all issuers, banks rely heavily on subordinated debt. To fully grasp its strategic importance, you need to see how regulatory capital requirements make it more than just a funding choice for the banks.
Why do Banks Use Subordinated Debt?
Banks issue subordinated debt primarily to strengthen their regulatory capital base without diluting equity. Under Basel III norms, as implemented by the Reserve Bank of India, certain long-term subordinated instruments qualify as Tier 2 capital. Tier 2 capital acts as a buffer that absorbs losses in the event of stress, after equity (Tier 1) but before depositors are impacted.
Regulations require banks to maintain minimum Capital Adequacy Ratios (CAR). So, when loan books expand, risk-weighted assets rise, and capital ratios can compress. Issuing subordinated debt allows banks to shore up capital ratios, support credit growth, and optimize return on equity, all without issuing fresh shares or diluting promoter ownership.
Regulatory usage explains the demand for subordinated debt, yet your investment decision ultimately depends on how it stacks up against senior debt in terms of priority, security, and returns.
Key Differences Between Senior Debt and Subordinated Debt
| Parameter | Senior Debt | Subordinated Debt |
| Repayment priority | Repaid first in case of liquidation or bankruptcy | Repaid only after all senior obligations are fully settled |
| Cost of borrowing | Lower interest rates due to lower risk | Higher interest rates to compensate for lower repayment priority |
| Security / collateral | Can be secured or unsecured; always has a higher claim | Usually unsecured and backed only by the issuer’s creditworthiness |
| Risk & recovery in default | Lower risk with higher recovery rates in distress situations | Higher risk with lower recovery potential if the issuer defaults |
Final Thoughts
When a company or bank issues subordinated debt, it often reflects a specific funding strategy: expanding aggressively, optimizing regulatory capital, or balancing leverage without issuing equity.
As an investor, your real task is not to chase only the coupon, but to also evaluate context. Read the offer document or term sheet carefully. Check where the instrument ranks in the repayment hierarchy, whether it has call options, loss-absorption clauses, or interest deferral features.
When you combine this with the company’s overall balance sheet position, you move one step closer to informed and successful fixed-income investing.
