Last September, I wrote an article entitled ‘Avoiding Pitfalls: Some Considerations Before Buying Corporate Bonds’, which was first published in the Sunday Times of Malta and later featured on the APS Bank website. In it, I introduced readers to key concepts in credit analysis and highlighted that beyond a company’s financial health, several other factors should guide investment decisions. A bond’s payment rank is one of the most important yet often overlooked features, as it stipulates an investor’s priority relative to other creditors should the issuer experience financial distress and defaults on its obligations. 

Assessing a company’s financial health tells us how likely it is to meet its obligations in the first place. But understanding payment rank goes a step further, because it shows where a bond sits within the company’s capital structure and provides insight into the level of loss investors may face in a worst-case scenario. 

When a business cannot meet all its obligations, not all bondholders are treated the same. At the top of the line are secured bondholders, those whose instruments are backed by specific assets. Next come unsecured bondholders, with senior creditors ranking ahead of holders of subordinated debt. 

Knowing a bond’s payment rank gives us a rough idea of who gets paid first, but the reality is much more complex. Can some creditors jump ahead of bondholders? Does a bond’s position in the corporate structure affect its repayment priority? Do all subordinated bonds absorb losses in the same way? And is a subordinated bond always riskier than a senior one? In the rest of this article, we take a closer look at each of these dimensions.  

Who Gets Paid Before Bondholders? 

When a company runs into serious trouble, bondholders are not always at the very front of the line. Certain obligations take priority over them.  

For example, banks that have provided loans to the company often have secured claims, giving them the right to recover capital before unsecured bondholders are paid. Similarly, governments have a legal right to collect taxes, meaning the tax collector can claim outstanding tax obligations ahead of many other creditors. 

Trade creditors, including suppliers and service providers, sometimes have preferential rights under local insolvency law, depending on the jurisdiction. In practice, this means that even senior bondholders may have to wait until these higher-priority claims are satisfied before they see any repayment. 

Practical tip: Before buying a bond, always review a company’s total debt and check what proportion is represented by bank debt or other higher-ranking obligations. Look for covenants that limit additional borrowing or prevent future debt from ranking more senior than existing obligations. This can give investors a clearer understanding of their true position in the repayment hierarchy and the potential recovery if things go wrong. 

Structural Subordination 

Structural subordination occurs when a lender to a parent company is pushed down the repayment line simply because of the corporate structure. Holders of bonds issued by a parent company rely on cash flows that sit inside subsidiaries, which must first satisfy their own creditors before pushing up cash flows to the parent. As a result, in a distress scenario the parent’s lenders are repaid only after subsidiary-level obligations are met. Worded differently, the location of the debt within the group often matters more than the label printed on the bond. 

This is different from contractual subordination, which is an explicit agreement that one debt ranks below another. Structural subordination happens automatically purely because of how the company is organised. 

Practical tip: When evaluating bonds issued either by a parent company within a corporate group or bonds issued by the financing arm of the group with a guarantee from the parent, always check how the group’s subsidiaries are financed. A senior unsecured bond at the parent level may be effectively lower in priority compared with unsecured debt issued directly by a subsidiary that controls its own cash flows.  

Not All Subordinated Bonds Are Created Equal 

Subordinated bonds rank below senior debt in the repayment line, but that doesn’t mean they all work the same way. For example, Tier 2 subordinated bonds issued by banks include regulatory bail-in features, designed to protect depositors and maintain financial stability without relying on taxpayer-funded bailouts if things go wrong. By contrast, subordinated bonds issued by non-financial companies do not face forced conversion or write-downs outside of bankruptcy. 

Practical tip: Before investing in subordinated bonds, check whether the bond is subject to regulatory bail-in provisions. This can significantly affect both the risk and potential recovery in an adverse scenario. 

A Bond’s Payment Rank Matters Most in Relation to Its Own Issuer 

A subordinated bond of one company is not automatically riskier than a senior bond of another company. Among other things, risk depends on the issuer’s credit quality, not just the nominal payment rank. 

For example, assume Company A issues a subordinated bond. Company A is well run by a strong management team, has a robust balance sheet, and enjoys diversified sources of revenue and strong cash generating capabilities. The subordinated bond of Company A is potentially less risky than a senior bond issued by Company B with weak financial metrics and highly cyclical revenues. This is often reflected in credit ratings on bonds traded overseas. Subordinated bonds issued by high-quality issuers, like large, well-capitalised banks, can carry better credit ratings than senior bonds issued by less creditworthy companies operating in other industries. 

Practical tip: Payment rank should not be used as a universal ranking across bonds issued by different companies. 

Conclusion 

Understanding a bond’s payment rank is more than a technical detail. A bond should not be judged by its label alone. In reality, assessing a company’s debt, its structure, covenants, and the specific features of a bond, especially if it is subordinated, can be complex and requires experience. 

Like many things that seem overwhelming, it pays to seek professional help. Whether through investment advice or delegating to a fund manager, expertise can make the difference between a well-informed investment and an unpleasant surprise. When it comes to bonds, knowing your place in line is not just smart, it can save your investment. 

Written by

David Lanzon, CFA

Senior Portfolio Manager – ReAPS Asset Management Ltd

The information contained in this article represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell/buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments. This article was issued by ReAPS Asset Management Limited, a subsidiary of APS Bank plc. ReAPS Asset Management Limited (C77747) with registered address at APS Centre, Tower Street, Birkirkara BKR 4012 is regulated by the Malta Financial Services Authority as a UCITS Management Company and to carry out Investment Services activities under the Investment Services Act 1994 and is registered as an Investment Manager under the Retirement Pensions Act.