Legal Definitions - subordinate debt

Subordinate debt refers to a type of loan or bond that ranks lower than other debts in terms of repayment priority. This means that if a company or individual defaults on their financial obligations or goes bankrupt, the holders of subordinate debt will only be paid back *after* all other senior creditors have been fully repaid. Because it carries a higher risk for the lender, subordinate debt often comes with a higher interest rate compared to senior debt.

• Example 1: Corporate Financing

  A growing software company secures a large bank loan to fund its daily operations and product development. Later, to finance a major acquisition, it issues "convertible notes" to a group of private equity investors. The terms of these convertible notes explicitly state that if the software company ever faces bankruptcy or liquidation, the bank loan must be fully repaid from any available assets before the private equity investors holding the convertible notes receive any funds. In this situation, the convertible notes are the subordinate debt because their repayment is secondary to the bank loan.

• Example 2: Real Estate Mortgages

  A homeowner has a primary mortgage on their house. Several years later, to pay for their child's college tuition, they take out a home equity line of credit (HELOC) from a different financial institution, using the same house as collateral. If the homeowner defaults on both loans and the house is foreclosed and sold, the proceeds from the sale will first be used to pay off the original primary mortgage lender. Only if there are funds remaining after the primary mortgage is fully satisfied will the HELOC lender receive payment. Here, the HELOC is the subordinate debt because its claim on the property's value is junior to the first mortgage.

• Example 3: Investment Funds

  An investment fund raises capital by issuing different classes of debt to investors. Some investors purchase "senior secured notes," which are backed by specific assets of the fund and have the highest repayment priority. Other investors purchase "subordinated debentures," which are unsecured and explicitly state that their holders will only be paid after all senior secured noteholders have been fully compensated in the event of the fund's insolvency. The subordinated debentures represent subordinate debt because their claim on the fund's assets is lower in rank than the senior secured notes.