Looking different subordinations and how they affect repayment risk

An important focus when looking the risk you accept from a credit products (loans, bonds) is the different subordination that is has relative to existing debt. Subordination is an assessment of how claims of one issuer of a credit product (e.g. junior loan) is ranked with respect to the claims of another issuers (e.g. senior loan).

So, the different subordinations are the followings:

1. Contractual subordination. The debt of the issuer that is defined as higher in the repayment rank ‘senior indebtedness’ under the loan documentation is expressly senior in right of payment to the loan.
2. Collateral subordination. The debt of the issuer that is secured by collateral effectively ranks senior in right of payment to the bonds to the extent of the liquidation value of the collateral.
3. Structural subordination. The debt or other obligations, such as trade credit, revolving loans, of the issuer’s subsidiaries that are NOT guarantors or co-obligors of the loan, can also effectively rank senior in right of payment of the initial loan, while the parent company hasn’t direct claim against the assets of those subsidiaries.

Contractual subordination

When issuing, a loan or a high-yield bonds usually is subordinated to the existing senior debt, in this cases the bonds contain contractual provisions that expressly subordinate the new debt in right of payment to other specified categories of higher seniority. Generally, contractual subordination provisions provide that, in the event of a bankruptcy or similar restructuring, all senior indebtedness must be paid in full before the subordinated notes can be paid.

Key points
The issuer’s senior lenders usually review and negotiate for specific protections in a bond’s subordination such as :

• Allow to senior lender to block interest and other payments on subordinated junior debt if there is a default under the senior loan agreements (usually for up to 180 consecutive days).
• Not to allow the the issue of new subordinated securities, to satisfy the junior bondholders’ claims, prior to satisfying the senior lenders’ claims in full

Collateral Subordination

Another way that debt can be effectively ranked ahead of bonds or unsecured senior debt is through the use of collateral. For example, it is usual for companies to have one or more credit facilities with various lending institutions. These credit facilities often include both a term loan and a revolving credit facility, which the issuer can access and repay over time to help manage working capital and other ongoing operational expenses.

For example, banks view revolving facilities as higher cost because they don’t know when or whether this credit lines will be used and therefore must reserve capital in the event that these facilities are drawn. As a result, there facilities have the most lender-friendly terms, including the benefit of collateral from the borrower to secure payment on any debt outstanding under the credit facilities. However, sometimes this collateral includes substantially all of the assets of an issuer. Moreover, certain types of facilities (such as asset-based loans), are secured by specific short-term assets, such as inventory and accounts receivable.

So there might be the case that a junior debt might have a liens to the corporate assets and effectively be higher in the rank towards senior debt in the liquidation process.

Key points

For the senior to be secured by these cases, when issued, the senior debt contains restrictive covenants that limit the ability of issuers to secure debt or other obligations ahead of the bonds. The typical liens covenant (or negative pledge) provides that an issuer may not secure debt or, in some cases, other obligations unless it provides an equal lien to secure the bonds (except for specified permitted liens).

Usually in most credit agreements they issuer prohibits all liens other than those in which the lien is for the specific credit line that financed the asset that has the lien. (for example, operating leases)

Structural subordination

Structural subordination is the most complicated of the three subordinations. It looks to the corporate structure of the issuer to determine ranking.

Structural subordination arises when the issuer of debt, such as high-yield bonds, is a parent company to other subsidiaries and particularly when an issuer is a holding company that does not have its own operations. In this situation, creditors of the subsidiaries (whether as lenders, bondholders, trade creditors or others) rank ahead of creditors of the parent.

This is because the subsidiary creditors have a claim against the assets of the obligor subsidiaries, whereas the parent company has only an equity claim as the owner of the subsidiaries’ common stock. Similarly, if the subsidiary issues preferred stock to parties other than the parent, then the claims of those preferred stockholders rank ahead of the issuer’s common stock claims.

For example, if there is legal claim against the subsidiary, then the claimant can enforce the legal decision against the actual assets of the subsidiary. On the other hand, the parent has to rely on the ability of the subsidiary to pay the parent dividends or similar distributions in order to recognise the value of the subsidiary’s assets.

In a bankruptcy or liquidation of the subsidiary, the previous claim ranks ahead of the parent’s creditors claims because the parent holds equity of the subsidiary, while the holds a senior claim verified by a court. As a result, creditors of the parent have an effectively claim equal to the equity interest.

Key points

Senior and junior debt respond in two ways to help protect against structural subordination to the parent issuer’s subsidiary obligors:

• Upstream guarantees of the bonds from subsidiaries.

Subsidiary guarantees are present in nearly all new issued debt in which an issuer has subsidiaries. This is because such a guarantee represents a direct debt claim against the subsidiary, ranking equally with other similar obligations of the subsidiary.

• Limitations on the ability of subsidiaries to incur debt and to restrict their ability to pay dividends.

By limiting the amount of debt that subsidiaries can incur, you also limit the amount that could rank effectively ahead of the parent’s claims. In the same manner, by limiting the ability to pay dividends, you limit loss of capital that could have been used for the repayment of the parent’s claims.