The court's decision dealt a blow to the Austrian government's attempt to spread the cost of winding down Hypo, now known as "bad bank" Heta, after taxpayers already poured €5.5 billion ($6.08 billion) into the failed bank.
Heta said that the ruling announced on Tuesday will cause a loss of €800 million plus interest in its balance sheet for the first half of the year.
Carinthia's (Hypo's home province) said its guarantees for debt owed by Heta will rise to €11 billion from €10.2 billion.
Austria took over Hypo from its former owner BayernLB in 2009 to avert a collapse and prevent potential fallout in central and eastern Europe, where large parts of Hypo's business was based.
Austria's state debt and budget deficit has swelled in the wake of the financial scandal, and a parliamentary investigation into who is to blame for the mess is ongoing.
The law, which the court rejected as "unconstitutional", was passed last year and effectively cancelled €890 million of subordinated debt guaranteed by Carinthia. It also required an €800 million payment from German state bank BayernLB.
Claims by junior bondholders will be reinstated and become subject to a debt moratorium imposed by Austria's FMA regulator this year, court president Gerhart Holzinger told journalists in Vienna.
The unequal treatment of some creditors is “a violation of the fundamental right to the protection of property,” the court said in a statement. Also, debt guarantees issued by a federal province can't be rendered completely invalid retroactively, the court said.
Groups fighting the junior debt cancellation include insurers like Uniqa Insurance Group AG and Vienna Insurance Group AG, fund managers like Deutsche Bank AG's DWS, and the World Bank.
The court's decision is independent from action taken by Austria's Financial Market Authority in March to impose a moratorium on debt repayments by Heta. This runs until May 2016 and is aimed at giving the watchdog time to find a solution with Heta's creditors.
A spokesman for the Constitutional Court said that Vienna's Commercial Court had requested it to look into whether the debt moratorium was legal. He added its investigations on average take nine months.
But Austria's Finance Ministry said the court ruling had no impact on the process of winding down Heta, which was set up last year to take on Hypo's assets, valued at the time at €18 billion.
The Constitutional Court's decision comes less than a month after Austria agreed to pay €1.23 billion to the German state of Bavaria to settle all the pending litigation over Heta. Under the deal, BayernLB will drop its claim concerning €800 million it was owed by Heta.