Also referred to as subordinate bonds, subordinated bonds are bond issues that are ranked below other forms of bonds in the event that the issuer must liquidate assets, either due to shutting down the enterprise, entering into bankruptcy, or undergoing some other form of severe financial distress. This secondary status means that any claims for payment to investors must wait until those bonds with more pressing claims are settled. While this may seem to be a major disadvantage to investing in bonds of this type, many investors find that the benefits outweigh the risks.
It is true that subordinated bonds carry a higher degree of risk than other types of bond issues classified as senior bonds or senior debt. The fact that the bonds don’t carry the same status as those with more seniority in a bankruptcy or dissolution situation is one of the reasons why the rate of return on subordinated bonds is usually higher than that of other bond types. This opportunity for a higher return is often enough to offset any concerns that investors have about the possibility of losing money if the bond issuer ceases to operate for any reason, or goes through a bankruptcy situation.
Subordinated bonds also tend to have a lower credit rating than other types of bonds. This is because most bonds of this type are issued by banks, and are used as a means of arranging debt. This makes the bonds somewhat more risk-sensitive. However, unless the bank closes and the corporation owning the bank is driven into bankruptcy, the chances of losing money on the bond issue are extremely slim.
When corporations issue subordinate bonds, it is usually because bond issues are a way to secure needed capital quickly, and without requiring the payment of additional compensation. For example, a bond issue of this type would make it possible to complete a project with less capital than taking out an unsecured loan. The return paid on the bond issue is likely to be less than the interest rate on any type of loan arrangement, a factor that can result in a significant amount of savings for the business.
In order to keep some perspective on the possibility of losing money on bonds, it should be noted that bond issues are often considered some of the safest investment options that an investor can make. This means that subordinated bonds are still likely to carry less risk than many types of stock options. The relative stability of bonds in general means that even a conservative investor is likely to find that subordinate bonds are still a good choice.