Subordinated Bond

Subordinated bonds are an essential yet complex aspect of the financial market, offering opportunities for higher returns but with accompanying risks. This guide aims to provide a comprehensive understanding of subordinated bonds, exploring their characteristics, types, and associated risks. Whether you’re a trader, a beginner, or new to investing, this article will equip you with the knowledge you need to navigate the world of subordinated bonds. 

What is a Subordinated Bond? 

A subordinated bond, often referred to as a subordinated debenture, is a type of debt security that ranks below other debts in the hierarchy of repayment. In the unfortunate event of a company’s bankruptcy or liquidation, the holders of subordinated bonds are only paid after the senior bondholders and other more senior creditors have been fully compensated. This lower ranking in the repayment order categorizes subordinated bonds as higher-risk investments. To compensate for this increased risk, subordinated bonds generally offer higher interest rates or yields compared to senior bonds. 

Understanding Subordinated Bond 

Subordinated bonds are unsecured, meaning they are not backed by specific assets. Their value is tied to the overall creditworthiness of the issuer. In the event of bankruptcy, the repayment order becomes critical, highlighting the inherent risk of subordinated bonds. Here’s the typical repayment hierarchy: 

• Senior Debt: This includes secured loans and senior bonds, which are paid first. 

• Subordinated Debt: Paid after all senior obligations have been met. 

• Equity Holders: Common and preferred shareholders paid last. 

This hierarchy is crucial for investors to understand as it directly impacts the level of risk they are exposed to. The lower position of subordinated bonds in the repayment order means that investors need to perform thorough due diligence, assessing the issuer’s financial health and capacity to meet its debt obligations. 

Types of Subordinated Bond 

Subordinated bonds come in various forms, each with unique features that may appeal to different types of investors. The most common types include: 

1. Mezzanine Debt: This type of subordinated bond is often used in corporate financing. Mezzanine debt typically ranks between senior debt and equity. It may include equity-like features, such as warrants, which give the bondholder the option to convert the bond into equity under certain conditions.

2. High-Yield Bonds: Also known as junk bonds, these subordinated bonds offer higher interest rates due to the increased risk associated with the issuer’s lower credit rating. High-yield bonds are often issued by companies with less stable financial conditions.

3. Payment-in-Kind (PIK) Notes: These bonds give issuers the option to pay interest in the form of additional bonds rather than cash, effectively deferring cash payments. PIK notes are typically used by companies seeking to preserve cash flow.

4. Vendor Notes: Often issued by companies to suppliers, these notes are a form of subordinated debt. They are typically used as part of a payment arrangement and are subordinated to other forms of debt, such as bank loans.

Covenants and Restriction 

Covenants are an integral part of subordinated bond agreements, acting as protective measures for bondholders. These covenants can be broadly categorised into two types: 

 Affirmative Covenants: These require the issuer to adhere to certain operational standards, such as maintaining adequate insurance, complying with legal requirements, and providing regular financial statements. These covenants are designed to ensure that the issuer remains financially healthy and capable of meeting its debt obligations. 

 Negative Covenants: These restrictions prevent the issuer from engaging in certain activities that could jeopardise the bondholders’ interests. For example, a negative covenant might restrict the issuer from taking on additional debt, selling key assets, or paying dividends without bondholder approval. 

Covenants are crucial for subordinated bonds because they help mitigate the risks associated with the lower priority of repayment. By imposing these restrictions, bondholders can be more confident that the issuer will maintain the financial stability necessary to meet its obligations. 

Examples of Subordinated Bond 

A subordinated bond represents a type of debt that ranks lower than senior debt in the event of a liquidation. For instance, consider a Singapore-based bank, OCBC, issuing SGD 500 million in subordinated notes with a coupon rate of 4.5%, due in 2034. You purchase one of these subordinated bonds for SGD 1,000 as an investor. Over the life of the bond, you receive annual interest payments of SGD 45 (4.5% of SGD 1,000).  

However, it is crucial to understand that in the event of the bank’s insolvency, subordinated bondholders would only be repaid after all senior debt obligations have been met. This means that while you enjoy higher yields compared to senior bonds, your investment carries a higher risk. If OCBC were to face financial difficulties, you might not recover your principal investment.  

Thus, subordinated bonds can be appealing for those seeking higher returns but come with the caveat of increased risk, making them suitable for investors with a higher risk tolerance looking for diversification in their fixed-income portfolios. 

Frequently Asked Questions