Subordinated debt is a type of corporate bond that is “junior” to other types of securities issued by a company. This means that if the issuing company were to fail, holders of subordinated debt will be paid after investors in other debt issued by the company.

What does this mean for the investor? In a very basic example, consider a company with $100 million in assets, $90 million of “senior” debt and $20 million of junior, or subordinated debt.


If the company went bankrupt, those assets would be used to pay back the senior debt first, and only then would the holders of the subordinated debt be paid - in this example, 50 cents on the dollar. In reality, however, the typical recovery rate on subordinated debt is only about 8-10% lower than the recovery rate on senior unsecured debt - the next step up in the capital structure. Capital structure, in this case, refers to the order in which creditors have a claim on assets.

Subordinated debt therefore has higher risk than bonds that are more senior in the capital structure. As a result, they also offer higher yields than senior debt (since risk and yield go hand-in-hand).

This is a trade-off many investors are willing to make. First, subordinated debt offers the same interest-rate risk as senior bonds of the same issuer, meaning that investors aren’t taking on more rate risk to shift into this market segment. Second, the majority of subordinated debt is issued by investment-grade companies that are rated BBB and above (think Goldman Sachs, Barclays Bank, Prudential Financial, etc.).

Under normal circumstances (as opposed to the 2008 financial crisis), it’s reasonable to expect that these companies are very stable issuers with long livs. This means that the only added risk of subordinated debt – being junior in the capital structure – is unlikely to be an issue.

The bottom line: many investors believe the added yields more than compensate for the modest additional risks, giving subordinated debt an attractive risk-and-return profile.

How to Invest in Subordinated Debt

While in the past investors didn’t have a direct way to own subordinated debt, that’s now possible thanks to the creation of the Deutsche X-trackers Solactive Investment Grade Subordinated Debt ETF (SUBD). The fund, which opened on May 1, 2014 and has an expense ratio of 0.45%, tracks the Solactive Subordinated Bond Index. As of April 30, 2014, the index had a yield-to-maturity of 4.04% and a duration of 7.27 years. You can find the fund’s home page here. Some investors may also own subordinated debt through their mutual fund investments, since many managers have sought opportunities in the space to boost yields in the current low-rate environment.

What to Expect From Subordinated Debt: Yield, Risk, and Price Performance

Since subordinated debt is simply another type of corporate bond, it will tend to track the broader corporate market over time. The factors that would lead to price movements in senior corporates – i.e., trends in economic growth, inflation, investors' appetite for risk, corporate performance, etc. –   will have a similar impact on the performance of subordinated debt. You can learn more about how these factors affect the returns of corporate bonds here.

When assessing the expected performance of subordinated debt, it’s important to keep in mind that the majority of issuers are financial companies, with a smattering of utilities also in the mix. This heavy sector concentration means that subordinated debt will diverge from the broader corporate bond market over time based on issues specific to the financial sector, such as regulation, earnings results, and interest-rate movements.

It’s easy to compare the performance of the two market segments: simply go to bigcharts.com and run an “Advanced” chart of the SUBD ETF, and then enter the ticker “LQD,” which is the iShares iBoxx $ Investment Grade Corporate Bond ETF. The resulting chart will show the comparative performance of the two ETFs.

In terms of yield, subordinated debt will offer an advantage over traditional corporates – after all, investors need to be paid to take on added risk. However, the gap isn’t substantial. As of September 2014, SUBD had a 30-day SEC yield of 3.57%, which compared with 3.11% for the LQD ETF. You can find updated yield numbers for the two ETFs here and here.

How Subordinated Debt Can Work in Your Portfolio

Since subordinated debt has performance characteristics similar to both corporates and the investment-grade market as a whole, it won’t necessarily provide diversification when added to a traditional fixed-income portfolio. However, it can be used as a partial replacement for other investment-grade funds – including index funds – thereby providing investors with a way to pick up a little bit of extra yield.